Tools of Financial Analysis and Control

Tools of Financial Analysis and Control (Performance Analysis).

1. LECTURE 2
PERFORMANCE ANALYSIS
(Tools for Financial Analysis and Control)

2. 2
Responsibilities of the Financial Manager
1. Managing the
working capital
2. Estimating the
seasonal fund needs
3. Long-term financial
planning: forecasting long-
term fund requirements
4. Determining appropriate
investment mix
6. Determining the
amount of dividends
to be paid
5. Determining appropriate
financing mix

3. Inter-relationships between financing,
investment and dividend decisions
Investment:
Company decides to
take on a large
number of attracting
new investment
projects
Finance: Company
will need to raise
finance in order to
take on projects
Dividends: if finance is
not available from
external sources,
dividends may need to be
cut in order to increase
internal financing
Dividends: company
decides to pay higher
levels of dividends to
shareholders
Finance: lower level
of retained earnings
available for
investment means
company may have to
find finance from
external sources
Investment: if finance is
not available from
external sources the
company may have to
postpone future
investment projects
Finance: company
finances itself using
more expensive
sources resulting in a
higher cost of capital
Investment: due to
a higher cost of
capital the number of
projects attractive to
the company
decreases
Dividends: the
company’s ability to pay
dividends in the future
will be adversely affected

4. Learning Activity
•What are the basic financial statements that
should be prepared by a business firm?
•What are the uses of each of the basic
financial statements?

5. Basic Financial Statements
•The Income Statement
•The Balance Sheet
•The Statement of Retained Earnings
•The Statement of Cash Flows

6. Learning Activity
•What is financial statement analysis and why
is it important?

7. •What is financial statement analysis?
”Tearing apart” the financial statements and
looking at the relationships
•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
Financial Statement Analysis

8. Significance of Financial Statements Analysis
•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 lax 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.

9. •Who analyzes financial statements?
–Internal users (i.e., management)
–External users (emphasis of lecture)
•Examples?
–Investors, creditors, regulatory agencies & …
–Financial analysts
–Auditors
–Researchers
–etc
Who Analyses Financial Statements?

10. A Firm’s Stakeholders
The firm
Customers
Society
Shareholders
Managers
Employees
Government
Creditors
A company has responsibility to different interested parties

11. •What do internal users use it for?
Planning, evaluating and controlling company
operations
•What do external users use it for?
Assessing past performance and current financial
position and making predictions about the future
profitability and solvency of the company as well
as evaluating the effectiveness of management
Financial Statement Analysis

12. Information is available from
–Published annual reports
(1) Financial statements
(2) Notes to financial statements
(3) Letters to stockholders
(4) Auditor’s report (Independent accountants)
(5) Management’s discussion and analysis
Financial Statement Analysis

13. Information is available from (Cont…)
–Other sources
(1)Newspapers (e.g., Business Times, Financial Times )
(2)Periodicals (e.g. Forbes, Fortune)
(3)Financial information organizations such as:
Moody’s, Standard & Poor’s, Dun & Bradstreet, Inc.,
and Robert Morris Associates
(4)Other business publications
Financial Statement Analysis

14. •Horizontal Analysis
•Vertical Analysis
•Common-Size Statements
•Trend Percentages
•Ratio Analysis
Methods of
Financial Statement Analysis

15. Horizontal Analysis
Using comparative financial statements to
calculate monetary (Tshs) or percentage
changes in a financial statement item from
one period to the next
Using comparative financial statements to
calculate monetary (Tshs) or percentage
changes in a financial statement item from
one period to the next

16. Vertical Analysis
For a single financial statement,
each item is expressed as a
percentage of a significant total,
e.g., all income statement items are
expressed as a percentage of sales
and all balance sheet items are
expressed as a percentage of total
assets
For a single financial statement,
each item is expressed as a
percentage of a significant total,
e.g., all income statement items are
expressed as a percentage of sales
and all balance sheet items are
expressed as a percentage of total
assets

17. Common-Size Statements
Financial statements that show
only percentages and no
absolute monetary amounts
Financial statements that show
only percentages and no
absolute monetary amounts

18. Trend Percentages
Show changes over time in
given financial statement items
(can help evaluate financial
information of several years)
Show changes over time in
given financial statement items
(can help evaluate financial
information of several years)

19. Ratio Analysis
Expression of logical relationships
between items in a financial statement of a
single period (e.g., percentage relationship
between revenue and net income)
Expression of logical relationships
between items in a financial statement of a
single period (e.g., percentage relationship
between revenue and net income)

20. Horizontal Analysis Example
Assume that the management of UD Co Ltd
provides you with comparative balance sheets
of the years ended December 31, 2014 and
2013. Management asks you to prepare a
horizontal analysis horizontal analysis on the information.

21. UD Company
Comparative Balance Sheet,
31 December,2013 and 2012
2013 2012 Increase (Decrease)
Amount %
Assets
Current Assets
Cash 12,00023,500
Accounts Receivable, Net60,00040,000
Inventory 80,000100,000
Prepaid Expenses 3,000 1,200
Total Current Assets 155,000164,700
Property and Equipment
Land 40,00040,000
Building & Equipment, Net120,00085,000
Total Land & Equipment160,000125,000
Total Assets 315,000289,700

22. Calculating Change in Tshs Amounts
Tshs
Change
Current Year
Figure
Base Year
Figure
= –
Horizontal Analysis Example

23. Calculating Change in Monetary Amounts
Since we are measuring the amount of the change
between 2012 and 2013, the Tshs amounts for
2012 become the “base” year figures.
Tshs
Change
Current Year
Figure
Base Year
Figure
= –
Horizontal Analysis Example

24. Calculating Change as a Percentage
Percentage
Change
Tshs Change
Base Year Figure
100%= ×
Horizontal Analysis Example

25. $12,000 – $23,500 = $(11,500)
Horizontal Analysis Example

26. ($11,500 ÷ $23,500) × 100% = 48.9%
Horizontal Analysis Example

27. Horizontal Analysis Example

28. 28
Horizontal Analysis Example
•Let’s apply the same procedures to the
liability and stockholders’ equity sections of
the balance sheet.

29. UD Co Ltd
Comparative Balance Sheets
December 31, 2014 and 2013
Increase
(Decrease)
2014 2013 Amount %
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable 67,000$ 44,000$ 23,000$ 52.3
Notes payable 3,000 6,000 (3,000) (50.0)
Total current liabilities 70,000 50,000 20,000 40.0
Long-term liabilities:
Bonds payable, 8% 75,000 80,000 (5,000) (6.3)
Total liabilities 145,000 130,000 15,000 11.5
Stockholders' equity:
Preferred stock 20,000 20,000 - 0.0
Common stock 60,000 60,000 - 0.0
Additional paid-in capital 10,000 10,000 - 0.0
Total paid-in capital 90,000 90,000 - 0.0
Retained earnings 80,000 69,700 10,300 14.8
Total stockholders' equity 170,000 159,700 10,300 6.4
Total liabilities and stockholders' equity 315,000$ 289,700$ 25,300$ 8.7

30. 30
Horizontal Analysis Example
•Now, let’s apply the procedures to the
income statement

31. UD Co Ltd
Comparative Income Statements
For the Years Ended December 31, 2014 and 2013
Increase (Decrease)
2014 2013 Amount %
Net sales 520,000$ 480,000$ 40,000$ 8.3
Cost of goods sold 360,000 315,000 45,000 14.3
Gross margin 160,000 165,000 (5,000) (3.0)
Operating expenses 128,600 126,000 2,600 2.1
Net operating income 31,400 39,000 (7,600) (19.5)
Interest expense 6,400 7,000 (600) (8.6)
Net income before taxes 25,000 32,000 (7,000) (21.9)
Less income taxes (30%) 7,500 9,600 (2,100) (21.9)
Net income 17,500$ 22,400$ (4,900)$ (21.9)

32. UD Co Ltd
Comparative Income Statements
For the Years Ended December 31, 2014 and 2013
Increase (Decrease)
2014 2013 Amount %
Net sales 520,000$ 480,000$ 40,000$ 8.3
Cost of goods sold 360,000 315,000 45,000 14.3
Gross margin 160,000 165,000 (5,000) (3.0)
Operating expenses 128,600 126,000 2,600 2.1
Net operating income 31,400 39,000 (7,600) (19.5)
Interest expense 6,400 7,000 (600) (8.6)
Net income before taxes 25,000 32,000 (7,000) (21.9)
Less income taxes (30%) 7,500 9,600 (2,100) (21.9)
Net income 17,500$ 22,400$ (4,900)$ (21.9)
Sales increased by 8.3% while net income
decreased by 21.9%.

33. UD Co Ltd
Comparative Income Statements
For the Years Ended December 31, 2013 and 2013
Increase (Decrease)
2014 2013 Amount %
Net sales 520,000$ 480,000$ 40,000$ 8.3
Cost of goods sold 360,000 315,000 45,000 14.3
Gross margin 160,000 165,000 (5,000) (3.0)
Operating expenses 128,600 126,000 2,600 2.1
Net operating income 31,400 39,000 (7,600) (19.5)
Interest expense 6,400 7,000 (600) (8.6)
Net income before taxes 25,000 32,000 (7,000) (21.9)
Less income taxes (30%) 7,500 9,600 (2,100) (21.9)
Net income 17,500$ 22,400$ (4,900)$ (21.9)
There were increases in both cost of goods sold (14.3%) and
operating expenses (2.1%). These increased costs more than
offset the increase in sales, yielding an overall decrease in net
income (21.9%).

34. Vertical Analysis Example
Assume that the management of BS Company
Ltd asks you to prepare a vertical analysis vertical analysis for
the comparative balance sheets of the
company.

35. Vertical Analysis Example

36. Vertical Analysis Example
$82,000 ÷ $483,000 = 17% rounded
$30,000 ÷ $387,000 = 8% rounded

37. Vertical Analysis Example
$76,000 ÷ $483,000 = 16% rounded

38. Trend Percentages Example
Assume that MD Co Ltd provides you with the
following operating data and asks that you
prepare a trend analysis.

39. Trend Percentages Example
Assume that MD Co Ltd provides you with the
following operating data and asks that you
prepare a trend analysis.
$1,991 - $1,820 = $171$1,991 - $1,820 = $171

40. Trend Percentages Example
Using 2010 as the base year, we develop the
following percentage relationships.
$1,991 - $1,820 = $171$1,991 - $1,820 = $171
$171 ÷ $1,820 = 9% rounded$171 ÷ $1,820 = 9% rounded

41. RATIO ANALYSIS
•Financial statements report both on a firm’s position
at a point in time and on its operations over some
past period.
•From management’s viewpoint, financial statement
analysis is useful both as a way to
–anticipate future conditions and
–more important, as a starting point for planning
actions
–that will influence the future course of events or
–to show whether a firm’s position has been
improving or deteriorating over time.

42. Ratio Analysis (Cont…)
•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

43. Ratios can be expressed in three different
ways:
1. Ratio (e.g., current ratio of 2:1)
2. % (e.g., profit margin of 2%)
3. $ (e.g., EPS of Tshs 225)
CAUTION!
“Using ratios and percentages without
considering the underlying causes may
lead to incorrect conclusions.”
Ratios

44. Major Categories of Ratios
•Liquidity Ratios
Indicate a company’s short-term debt-paying ability
•Asset Management
Measure how effectively the firm is managing/using its
assets
•Equity (Long-Term Solvency) Ratios
Show relationship between debt and equity financing
in a company
•Profitability Tests
Relate income to other variables
•Market Tests
Help assess relative merits of stocks in the market
place

45. The 10 Basic Ratios you have to know
•Liquidity Ratios
1.Current Ratio (Working Capital Ratio)
2.Quick Ratio/Acid Test Ratio
Cash Ratio/Cash Flow liquidity Ratio
•Asset Management Ratios
3.Inventory Turnover Ratio
4.Days Sales Outstanding
5.Inventory Turnover Ratio
Fixed Assets Turnover Ratio
Total Assets Turnover Ratio
•Equity (Long-term solvency/Debt Management Ratios
6.Equity (stockholders’ equity) ratio - Equity to debt
Total Debt to Total Assets Ratio
Times Interest Covered Ratio

46. The 10 Basic Ratios you have to know
•Profitability Ratios
7.Profit Margin - Net income to net sales (return on sales)
8.Earnings per share
9.Return on average common stockholders’ equity (ROEROE)
•Return on Assets
•Return on Equity
•Basic Earning Power Ratio
•Cash flow margin
•Times interest earned
•Times preferred dividends earned

47. The 10 Basic Ratios you have to know
•Market Tests
10.Price-earnings ratio
•Earnings yield on common stock
•Payout ratio on common stock
•Dividend yield on common stock
•Dividend yield on preferred stock
•Cash flow per share of common stock

48. Ratio Analysis - Example

52. Ratio Analysis - Example
•Calculate the 10 basic ratios based on Neema
Co Ltd’s financial statements

53. Neema Co Ltd
2014
Cash 30,000$
Accounts receivable, net
Beginning of year 17,000
End of year 20,000
Inventory
Beginning of year 10,000
End of year 12,000
Total current assets 65,000
Total current liabilities 42,000
Sales on account 494,000
Cost of goods sold 140,000
We will
use this
information
to calculate
the liquidity
ratios for
Neema Co Ltd.

54. Working Capital*
12/31/14
Current assets 65,000$
Current liabilities (42,000)
Working capital 23,000$
The excess of current assets over current liabilities.
* While this is not a ratio, it does give an
indication of a company’s liquidity.

55. Current (Working Capital) Ratio
Current
Ratio
$65,000
$42,000
= =1.55 : 1
Measures the ability of the company to
pay current debts as they become due.
Current
Ratio
Current Assets
Current Liabilities
=
#1#1

56. Acid-Test (Quick) Ratio
Quick Assets
Current Liabilities
=Acid-Test Ratio
Quick assets are Cash, Marketable Securities,
Accounts Receivable (net) and current Notes
Receivable.
#2#2

57. Quick Assets
Current Liabilities
=Acid-Test
Ratio
Neema Co Ltd’s quick assets consist of cash of
$30,000 and accounts receivable of $20,000.
Acid-Test (Quick) Ratio
#2#2

58. Quick Assets
Current Liabilities
=Acid-Test Ratio
$50,000
$42,000
=1.19 : 1=Acid-Test Ratio
Acid-Test (Quick) Ratio
#2#2

59. Sales on Account
Average Accounts Receivable
Accounts
Receivable
Turnover
=
Accounts Receivable Turnover
= 26.70 times
$494,000
($17,000 + $20,000) ÷ 2
Accounts
Receivable
Turnover
=
This ratio measures how many
times a company converts its
receivables into cash each year.
#3#3Average, net accounts
receivable
Net, credit sales

60. Number of Days’ Sales
in Accounts Receivable
Measures, on average, how many days
it takes to collect an account receivable.
Days’ Sales
in Accounts
Receivables
=
365 Days
Accounts Receivable Turnover
= 13.67 days
=
365 Days
26.70 Times
Days’ Sales
in Accounts
Receivables
#4#4

61. Number of Days’ Sales
in Accounts Receivable
In practice, would 45 days be a desirable
number of days in receivables?
#4#4
Days’ Sales
in Accounts
Receivables
=
365 Days
Accounts Receivable Turnover
= 13.67 days
=
365 Days
26.70 Times
Days’ Sales
in Accounts
Receivables

62. Inventory Turnover
Cost of Goods Sold
Average Inventory
Inventory
Turnover
=
Measures the number of times inventory is
sold and replaced during the year.
= 12.73 times
$140,000
($10,000 + $12,000) ÷ 2
Inventory
Turnover
=
#5#5

63. Inventory Turnover
Cost of Goods Sold
Average Inventory
Inventory
Turnover
=
Would 5 be a desirable number of times
for inventory to turnover?
= 12.73 times
$140,000
($10,000 + $12,000) ÷ 2
Inventory
Turnover
=
#5#5

64. Equity, or Long–Term
Solvency Ratios
This is part of the information to calculate the
equity, or long-term solvency ratios of Norton
Corporation.
Neema Co Ltd
2014
Net operating income 84,000$
Net sales 494,000
Interest expense 7,300
Total stockholders' equity234,390

65. Neema Co Ltd
2014
Common shares outstanding
Beginning of year 17,000
End of year 27,400
Net income 53,690$
Stockholders' equity
Beginning of year 180,000
End of year 234,390
Dividends per share 2
Dec. 31 market price/share 20
Interest expense 7,300
Total assets
Beginning of year 300,000
End of year 346,390
Here is the
rest of the
information
we will
use.

66. Equity Ratio
Equity
Ratio
=
Stockholders’ Equity
Total Assets
Equity
Ratio
=
$234,390
$346,390
67.7%=
Measures the proportion of total assets provided by
stockholders.
#6#6

67. Net Income to Net Sales
A.K.A. Return on Sales or Profit Margin
Net Income
To Net Sales
=
Net Income
Net Sales
Net Income
To Net Sales=
$53,690
$494,000
= 10.9%
Measures the proportion of the sales (Tshs)
which is retained as profit.
#7#7

68. Net Income to Net Sales
A.K.A. Return on Sales or Profit Margin
Net Income
To Net Sales
=
Net Income
Net Sales
Net Income
To Net Sales
=
$53,690
$494,000
= 10.9%
Would a 1% return on sales be good?
#7#7

69. Return on Average Common
Stockholders’ Equity (ROE)
Return on
Stockholders’
Equity
=
Net Income
Average Common
Stockholders’ Equity
=
$53,690
($180,000 + $234,390) ÷ 2
= 25.9%
Return on
Stockholders’
Equity
Important measure of the income-producing ability
of a company.
#8#8

70. Earnings
per Share
Earnings Available to Common Stockholders
Weighted-Average Number of Common Shares
Outstanding
=
Earnings
per Share
$53,690
(17,000 + 27,400) ÷ 2
= = $2.42
The financial press regularly publishes
actual and forecasted EPS amounts.
#9#9
Earnings Per Share

71. Price-Earnings Ratio
A.K.A. P/E Multiple
Price-Earnings
Ratio
Market Price Per Share
EPS
=
Price-Earnings
Ratio
=
$20.00
$ 2.42
= 8.3 : 1
#10#10
Provides some measure of whether the
stock is under or overpriced.

72. 72
The DuPont System
•Developed in 1919 by a finance executive at
E.I. du Pont de Nemours and Co
•A way of visualizing the information so that
everyone can see it
•Is a good tool for getting people started in
understanding how they can have an impact
on results
•It is a simple and straightforward method for
assessing the factors that influence a firm’s
financial performance

73. 73
The DuPont System
•Method to breakdown ROE into:
–ROA and Equity Multiplier
•ROA is further broken down as:
–Profit Margin (profitability)
–Asset Turnover (efficiency in using the assets)
•Helps to identify sources of strength and
weakness in current performance
•Helps to focus attention on value drivers

74. DuPont Chart and Equation
•DuPont Chart and Equation - Tie the Ratios
Together
–Shows how profit margin, asset turnover ratio,
and equity multiplier determine ROE
–Shows how expense control (profit margin),
efficient use of assets in production (asset
turnover) and capital structure (equity multiplier)
affect return on equity.
–Ties together all aspects of firm - production and
financing.

75. 75
Return on Equity - ROE
•This represents the Net income generated by
the Equity invested in the business
•The Formula is:
Net Income
Equity
–This represents amount of profit per Tshs invested
by the shareholders.

76. 76
DuPont System – What is It?
•The system identifies profitability as being impacted by
three different levers:
–Earnings & efficiency in earnings
–Ability of your assets to be turned into profits
–Financial leverage
•DuPont analysis tells us that ROE is affected by three
things:
–Operating efficiency, which is measured by profit margin.
–Asset use efficiency, which is measured by total asset
turnover.
–Financial leverage is measured by the equity multiplier
Earnings
Efficiency
Leverage

77. 77
Net Income
Total Equity
=
Net Income
Sales
X
Sales
Total Assets
Profitability
Asset Usage
Efficiency

Net
Profit
Margin
ROE
Total
Asset
Turnover
X
Debt
Ratio
Leverage
Total Assets
Total Equity

78. 78

79. 79
The DuPont System
P r o f i t M a r g i n T o t a l A s s e t T u r n o v e r
R O A E q u i t y M u l t i p l i e r
R O E

80. 80
The DuPont System
P r o f i t M a r g i n T o t a l A s s e t T u r n o v e r
R O A E q u i t y M u l t i p l i e r
R O E
Notice that using more debt (and less equity) to finance assets
raises the Equity Multiplier. This has two effects for stockholders.
The Equity Multiplier acts as a lever to magnify the effects of ROA
on returns for stockholders. If ROA is positive, ROE is a larger
positive value, but if ROA is negative ROE is a larger negative.

81. 81
The DuPont System
P r o f i t M a r g i n T o t a l A s s e t T u r n o v e r
R O A E q u i t y M u l t i p l i e r
R O E
Return on Assets is affected by two areas of operations. The Profit Margin
measures the degree to which the firm controls expenses. Since expenses comprise
the difference between Sales and Net Income, lowering the expenses taken out of
each shilling of sales raises the Profit Margin.
At the same time, Return on Assets can be raised by producing sales by using fewer
assets. Asset Turnover measures the sales produced with each shilling invested in
assets. This is often thought of as sales volume.
Different industries achieve ROA in different ways. Some have low profit margins
but high volume, e.g. grocery stores. Others have lower volume but are able to
maintain higher profit margins, e.g. car dealerships.

82. 82
The DuPont System
P r o f i t M a r g i n T o t a l A s s e t T u r n o v e r
R O A E q u i t y M u l t i p l i e r
R O E

83. 83
DuPont Equation
EquityCommon
Assets Total
Assets Total
Sales
Sales
IncomeNet
MultiplierEquity TurnoverAsset TotalMarginProfit ROE
´´=
´´=

84. 84
Operating
Profit Margin
Asset
Turnover
Return On
Assets (less
interest adj.)
Financial
Structure
Return On
Equity
X =
X =
Income
Stream
Investment
Stream
Asset Efficiency Usage
Leverage
DuPont System
Earnings/Profitability

85. 85
Operating
Profit Margin
Asset
Turnover
Return On
Assets (less
interest adj.)
Financial
Structure
Return On
Equity
X =
X =
Income
Stream
Investment
Stream
Profitability
Efficiency
Leverage
DuPont System Ratios

86. Problems in Financial Statement and
Ratio Analysis
•Developing and Using Comparative Data
•Distortion of Comparative Data
•Notes to Financial Statements
•Interpretation of Results
•Differences in Accounting Treatment
•Window Dressing
•Effects of Inflation

87. Important Considerations
•Need for comparable data
–Data is provided by companies such as Dun &
Bradstreet, Standard & Poor’s etc.
–Must compare by industry
–Is EPS comparable?
•Influence of external factors
–General business conditions
–Seasonal nature of business operations
•Impact of inflation