Ch02-ppt-Fin Statement Analysis Updated.pdf

Fin Statement Analysis Updated

1. 1
Analysis of Financial Statements

2. Meaning of Financial Statements
•Financial statements are summaries of the
operating, financing, and investment activities
of a firm.
•According to the International Accounting
Standards Board (IASB), the financial
statements of a firm should provide sufficient
information that is useful to
•investors and
•creditors
•in making their investment and credit
decisions in an informed way.

3. Meaning of Financial Statements Cont.
•The financial statements are expected to be prepared in
accordance with a set of standards known as IFRS.
•The financial statements of publicly traded firms must
be audited at least annually by independent public
accountants.
•The auditors are expected to attest to the fact that
these financial statements of a firm have been prepared
in accordance with IFRS.

4. Significance of Financial Statements
•Financial statements summarize and provide an
overview of events relating to the functioning of a
firm.

•Financial statement analysis helps identify
•a firm’s strengths and
•weaknesses
•so that management can take advantage of a
firm’s strengths and make plans to counter
weaknesses of the firm.

•The strengths must be understood if they are to be
used to proper advantage and weaknesses must be
recognized if corrective action needs to be taken

5. •For example, are inventories adequate to support the
projected level of sales?
•Does the firm have too heavy an investment in
account receivable?
•Does large account receivable reflect a relax
collection policy?
•To ensure efficient operations of a firm’s
manufacturing facility, does the firm have too much
or too little invested in plant and equipment?
Financial statement analysis provides answers to all
of these questions.

Significance of Financial Statements Cont.

6. 6
Financial Statements and Reports
•The Income Statement

•The Balance Sheet

•Statement of Cash Flows

•Statement of Retained Earnings

7. Simple Balance Sheet
7

8. The Balance Sheet
•Cash and equivalents versus other assets
•Accounting alternatives
•Breakdown of the common equity account
•Book values versus market values
•The time dimension
8

9. Unilate Textiles: December 31 Balance Sheets
9

10. 10

11. 11
Unilate Textiles: Comparative Balance Sheets

12. 12
Unilate Textiles: Liabilities and Equity

13. The Income Statement
13
Should Firms with Identical Assets/Operations
Report the Same Net Income?

Does Net Income Determine Value?

14. Unilate Textiles: Income Statement
14

15. 15
Unilate Textiles: Comparative
Income Statements

Earnings available to
common
stockholders

16. 16
Unilate Textiles: Statement of
Retained Earnings
Balance of retained earnings Dec. 31, 2008$260
Add: 2009 Net Income54
Less: 2009 dividends to stockholders ( 29)
Balance of retained earnings Dec. 31, 2009$285

17. Cash Flow Statement
•A statement of a firm that summarize
its sources and uses of fund over a
specific period.
17

18. Cash flow Statement
18
Net Income after tax Net Loss
Depreciation Dividend paid
Sale of stock Repurchase of stock

19. Concern for Cash Flow Statement
•Dividends are paid in cash. Since the
relationship between NI and CF is not
precise, investors are concerned.
•Ability to take advantage of growth
opportunity depends on availability of
cash flow in assets. So, investors and
managements are concerned.
19

20. Preparing cash flow statement
•Step 1: Calculate the B/S changes in assets,
liabilities and OE over the period of concern.
•Step 2: Classify each changes as a source or
a use.
•Step 3: Separately sum all sources and all
uses. If sum of sources = sum of uses,
sources and uses are classified correctly.
20

21. Preparing cash flow statement cont.
•Step 4: Net profit after tax and depreciation
data are taken from income statement.
Dividend is calculated.
Div. = Net Income After Tax - Change in R/E
•Classify relevant data in the following
categories:
1. Cash flow from operating activities
2. Cash flow from Investment activities
3. Cash flow from Financing activities



21

22. Cash flow Statement Cont.
22

23. 23
Unilate Textiles: Statement of Cash Flows

24. 24
Unilate Textiles: Statement of Cash Flows Continued

25. 25
Unilate Textiles: Statement of Cash Flows Continued

26. Exercise

27. (a) Creditors lend money to companies with the
expectation that they will be repaid at a specified point
in time in the future. If a company is generating cash
from operations in excess of its investing needs, it is
more likely that it will be able to repay its creditors. Not
only did Xerox actually have negative cash from
operations, but all of the cash it received in order to
meet its cash deficiency was from issuing new debt.
Both of these facts would be of concern to the
company’s creditors, since it would suggest it will be
less likely to be able to repay its debts.

28. (b) As a stockholder you are interested in the
long-term performance of a company and how that
translates into its stock price. Often during the early
years of a company’s life its cash provided by
operations is not sufficient to meet its investment
needs, so the company will have to get cash from
outside sources. However, in the case of Xerox, the
company has operated for many years and has a well
established name brand. The negative cash from
operations might suggest operating deficiencies.

29. (c) The statement of cash flows reports information on
a cash basis. An investor cannot get the complete
story on the company’s performance and financial
position without looking at the income statement and
balance sheet. Also, investors would want to look at
more than one year’s worth of data. The current year
might not be representative of past or future years.

30. (d)Xerox is a well known company. It has a past
record of paying dividends. Its management probably
decided to continue to pay a dividend to demonstrate
confidence in the company’s future. They may have
felt that by not paying the dividend for the year they
would send a negative message to investors.
However, by choosing to pay a cash dividend the
company obviously weakened its cash position, and
decreased its ability to repay its debts.

31. 31
What Information Do Investors Use
from Financial Statements
•Net working capital
•= NWC = Current assets - Current liabilities
Net operating working capital
= Current assets – Non interest bearing Current liabilities
•Operating cash flow
•= NOI (1-Tax rate) + Depreciation and amortization expense
•= Net operating profit after taxes + Depreciation and amortization
expense
•Free cash flow
•= FCF = operating cash flow - Investments
•= Operating cash flow - (Δ in fixed assets + ΔNOWC)
•Economic Value Added
•=EVA = NOI (1 - Tax rate) - [(Invested capital) X (After-tax cost of
capital as a percent)]

32. •Consider a firm that reported net operating
income equal to $40,000 this year.
Examination of the company’s balance sheet
and income statement shows that the tax rate
was 40 percent, the depreciation expense
was $5,000, $25,000 was invested in assets
during the year, and invested capital equals
$200,000. (1) What was the operating cash
flow that the firm generated during the year?
(2) What was the firm’s free cash flow? (3)
What was the firm’s EVA if its average cost of
funds is 8 percent after taxes?
32

33. 33
Ratio Analysis
•Analysis of a firm’s ratios is generally the first
step in financial analysis.

•Ratios are designed to show relationships
between financial statement accounts within
firms and between firms.

34. 34
What is the Purpose of Ratio Analysis?
•Give an idea of how well the company is doing
•Standardize numbers to facilitate comparisons
•Ratio analysis begins
•with the calculation of a set of financial ratios
•designed to show the relative strengths and
•weaknesses of a company as compared to
•Other firms in the industry
•Leadings firms in the industry
•The previous year of the same firm
•Ratio analysis helps to show whether the firm’s position
has been improving or deteriorating
•Ratio analysis can also help plan for the future

35. 35
What Are the Five Major Categories of Ratios?
What Questions Do They Answer?
•Liquidity: Can we make required payments in the
current period?
•Asset mgt.: Right amount of assets vs. sales?
•Debt mgt.: Right mix of debt and equity?
•Profitability: Do sales prices exceed unit costs,
and are sales high enough as reflected in PM,
ROE, and ROA?
•Market values: Do investors like what they see as
reflected in P/E and M/B ratios?

36. 36
Industry Average Data

37. Liquidity Ratio:
37
❖ Current Ratio

❖ Quick/Acid test Ratio

38. 38
What is Unilate’s Current Ratio?
Current Ratio = Current Assets
Current Liabilities
$465.0
$130.0
= =3.6 times
Industry average = 4.1 times

39. 39
What is Unilate’s Quick, or Acid Test Ratio?
Industry average = 2.1 times
$465.0 - $270.0
$130.0
Quick Ratio =
Current Assets- Inventories
Current Liabilities
= = = 1.5 times
$195.0
$130.0

40. 40
Liquidity ratios
Indicate for each action whether the current ratio, the
quick ratio and the cash ratio will increase (I), decrease
(D) or not change (NC). Assume net working capital is
positive.
Current Quick Cash
1. Short-term debt is paid ______ ______ _____
2. Long-term debt is paid ______ ______ _____
3. Inventory is sold on credit at a profit ______ ______ _____
4. Inventory is sold for cash at cost ______ ______ _____
5. A customer pays their bill ______ ______ _____
6. Inventory is purchased on accounts
payable ______ ______ _____
7. Inventory is purchased for cash
8. Cash is received from long-term loan______ ______ _____

41. 41
Liquidity ratios

Current Quick Cash
1. Short-term debt is paid I I I
2. Long-term debt is paid D D D
3. Inventory is sold on credit at a profit I I NC
4. Inventory is sold for cash at cost NC I I
5. A customer pays their billNC NC I
6. Inventory is purchased on accounts
payable D D D
7. Inventory is purchased for cash NC D D
8. Cash is received from long-term loan I I I

42. 42
Unilate’s Liquidity Position
•Ratios is slightly below industry average.

•Inventories are the least liquid of Unilate’s assets
and they are the assets that suffer losses in the
event of a forced sale.

•The quick ratio shows that, if receivables are
collected in full, Unilate can payoff its current
liabilities without having to liquidate its inventory.

43. Asset Management Ratios
•Inventory Turnover Ratio
•Days Sales Outstanding Ratio
•Fixed Assets Turnover Ratio
•Total Assets Turnover Ratios

43

44. 44
What is Unilate’s Inventory Turnover Ratio?
Industry average = 7.4 times
=
$1,230.0
$270.0
=4.6. times

45. 45
Comments on Unilate’s Inventory Turnover
•Compares poorly with industry

•May be holding excess inventories

•May be holding old/obsolete inventory

46. 46
Unilate’s Days Sales Outstanding Ratio
Industry average = 32.1 days
Note: Use Annual CREDIT sales, if available

47. 47
Unilate’s Fixed Assets Turnover Ratio
=
$1,500.0
$380.0
= 3.9 times
= 4.0 timesIndustry Average

48. 48
Unilate’s Total Assets Turnover Ratios?
=
$1,500.0
$845.0
=1.8 times
= 2.1 timesIndustry Average

49. 49
Unilate’s Fixed Assets Turnover and
Total Assets Turnover
•Total asset turnover is below industry
average.
•Unilate might have excess inventories
and receivables.

50. Debt Management Ratios
•Debt Ratio
•Times-Interest-Earned Ratio
•Fixed Charge Coverage Ratio
50

51. 51
Calculate the Debt
Ratio
Debt Ratio = Total debt
Total assets
=
+
=
$130.0.$300.0.
$845.0
45.0%
=
$430.0
$845.0
=0.509 = 50.9%
Industry Average

52. 52
Times-Interest-Earned Ratio
TIE = EBIT
Interest charges
3.3 times
$40.0
$130.0
==
Industry Average = 6.5 times

53. 53
Fixed Charge Coverage Ratio
All three previous ratios reflect use of debt, but focus on different aspects.
Industry Average = 5.8x

54. 54
Profitability Ratios
•Net Profit Margin
•Return on Total Assets
•Return on Common Equity

55. 55
Unilate’s Profit Margin
4.7%Industry Average =
$54.0
$1,500
0.036 = 3.6%==

56. 56
Unilate’s ROA, and ROE
12.6%Industry Average =
17.2%Industry Average =
$54.0
$845.0
= 0.064 = 6.4%=
$54.0
$415.0
= 0.130 = 13.0%
=

57. 57
Unilate’s Market Value Ratios
Price/Earnings Ratio
10.6 times
$2.16
$23.00
==
13.0 timesIndustry Average =

58. 58
Unilate’s Market Value Ratios
Market/Book Ratio
=
$23.00
$16.00
1.4 times
=
2.0 timesIndustry Average =

59. 59
2005 2006 2007 2008 2009
18
17
16
15
14
13
12
11
10
Rate of Return on
Common Equity
Unilate
Industry

60. 60
Summary of Ratio Analysis:
The DuPont Equation
ROA = Net Profit Margin X Total Assets Turnover
Net Income
Sales
Sales
Total Assets
X
=
$54.0
$1,500.0
X
=
$1,500.0
$845.0
= 3.6% X 1.8 = 6.4%

61. The DuPont Equation Cont.
61

62. 62
DuPont Equation Provides Overview
•Firm’s profitability (measured by ROA)

•Firm’s expense control (measured by profit
margin)

•Firm’s asset utilization (measured by total
asset turnover)

63. 63
What are Some Potential Problems and
Limitations of Financial Ratio Analysis?
•Comparison with industry averages is
difficult if the firm operates many
different divisions.
•“Average” performance not necessarily
good.
•Inflation distorts balance sheets.

64. 64
More Problems and
Limitations of Ratio Analysis
•Seasonal factors can distort ratios.
•“Window dressing” techniques can
make statements and ratios look
better.
•Different operating and accounting
practices distort comparisons.

65. 65
Still More Problems and
Limitations of Ratio Analysis
•Sometimes hard to tell whether a ratio
is “good” or “bad”
•Difficult to tell whether company is, on
balance, in strong or weak position

66. 66
Chapter 2 Essentials
•What financial statements do corporations
publish?
•Balance sheet, income statement, statement of cash
flows, and statement of retained earnings
•How do investors utilize financial statements?
•Debtholders estimate future cash flows to determine
whether the debt contracts will be honored
•Stockholders estimate future cash flows to determine the
value of the firm’s common stock.

67. 67
Chapter 2 Essentials
•What is ratio analysis and why are the results
important to both managers and investors?
•Ratio analysis is used to evaluate a firm’s current financial
position and the direction this position is expected to take in
the future.
•What is the most important factor in financial
statement analysis?
•To form general impressions about a firm’s financial position,
judgment must be used when interpreting financial ratios

68. Problem
•Hindelang Corporation has $1,312,500 in current
assets and $525,000 in current liabilities. Its initial
inventory level is $375,000, and it will raise funds
through additional notes payable and use them to
increase inventory. How much can Hindelang’s
short-term debt (notes payable) increase without
pushing its current ratio below 2.0? What will be
the firm’s quick ratio after Hindelang has raised
the maximum amount of short-term funds?
68

69. Problem
•W. F. Bailey Company had a quick ratio
of 1.4, a current ratio of 3.0, an
inventory turnover ratio of 5, total
current assets of $810,000, and cash
and equivalents of $120,000 in 2009. If
the cost of goods sold equaled 86
percent of sales, what were Bailey’s
annual sales and DSO?
69

70. 70

71. Three more ratios
•The Internal Growth Rate
The internal growth rate tells us how much the firm can
grow assets using retained earnings as the only
source of financing.

72. Three more ratios (Cont.)
•The Sustainable Growth Rate
The sustainable growth rate tells us how much the firm
can grow by using internally generated funds and
issuing debt to maintain a constant debt ratio.

73. Three more ratios (Cont.)

The cash conversion cycle
•To analyze the effectiveness of a firm’s working capital
management process cash conversion cycle (CCC) Model
are used.

•The cash conversion cycle focuses on the length of time
from the payment for the purchase of raw materials to
manufacture a product until the collection of accounts
receivable associated with the sale of the product


73

74. The cash conversion cycle

74

75. The cash conversion cycle
75