Financial Analysis Techniques Chapter 15

Study Notes

Chapter 15: Financial Analysis: The Big Picture

This chapter focuses on financial analysis techniques, including horizontal analysis, vertical analysis, and ratio analysis.
Learning Objectives include applying these analyses to financial statements, evaluating company performance using ratio analysis, and understanding sustainable income.
The need for comparative analysis is highlighted—all items in financial statements are significant, and various analytical techniques are necessary to assess their importance.
Key characteristics for analysis include liquidity, profitability, and solvency.
Comparative analysis bases could include intra-company, industry averages, and inter-company comparisons.
Different analysis tools include horizontal analysis, vertical analysis, and ratio analysis.

Learning Objective 2: Analyze a Company's Performance Using Ratio Analysis

Ratio analysis examines the relationships within financial statement data for selected items.
Liquidity ratios evaluate a company's short-term ability to meet its obligations and unexpected cash needs. Commonly used examples include current ratio, acid-test, accounts receivable turnover, and inventory turnover.
Profitability ratios measure the income or operational success over a given period. They include profit margin, asset turnover, return on assets, return on equity, earnings per share (EPS), and payout ratio.
Solvency ratios determine the company's long-term survival potential. They include debt to total assets and times interest earned.

Ratio Analysis Details

Liquidity Ratios: Measure short-term ability to pay obligations.
Profitability Ratios: Measure operating success over a given time period. This includes factors like income, growth abilities, debt ability, and more.
Solvency Ratios: Evaluate the company's ability to survive over a longer period. They indicate a company's ability to meet both debts and interest payments.

Specific Ratio Examples

Current Ratio: Calculated as Current Assets / Current Liabilities. A higher ratio typically indicates better short-term liquidity.
Acid-Test Ratio: A more stringent liquidity measure than the current ratio (Current Assets - Inventory) / Current Liabilities).
Accounts Receivable Turnover: Measures the efficiency of collecting receivables; calculated as Net Credit Sales / Average Accounts Receivable.
Inventory Turnover: A measure of how efficiently inventory is sold; calculated as Cost of Goods Sold / Average Inventory
Profit Margin: The percentage of sales that result in net income; calculated as Net Income / Net Sales.
Asset Turnover: Measures asset use efficiency regarding generating sales; calculated as Net Sales / Average Total Assets.
Return on Assets (ROA): Shows overall profitability using assets; calculated as Net Income / Average Total Assets.
Return on Ordinary Shareholders' Equity (ROE): A measure of the return on the owners' investment; calculated as (Net Income - Preference Dividends) / Average Ordinary Shareholders' Equity.
Earnings per Share (EPS): Measures net income per outstanding ordinary share; calculated as Net Income - Preference Dividends / Weighted-Average Ordinary Shares Outstanding.
Price-Earnings Ratio (PE Ratio): A measure of investors' views of future earnings; calculated as Market Price per Share / Earnings per Share.
Payout Ratio: Indicates the percentage of earnings distributed to shareholders as dividends; calculated as Cash Dividends Declared on Ordinary Shares / Net Income.
Debt to Assets Ratio: Measures the percentage of assets provided by creditors; calculated as Total Liabilities / Total Assets.
Times Interest Earned: Measures a company's capacity to meet interest payments; calculated as (Net Income + Interest Expense + Income Tax Expense) / Interest Expense

Statement of Financial Position

This statement presents the financial position of a company at a specific point in time; Assets, Liabilities, and Equity are key components. Key information includes assets, liabilities and equity details for companies over different time periods.

Income Statement

This statement presents a company's financial performance over a period of time; revenues, expenses, and net income are important components. Details here include sales, cost of goods sold, gross profit, and expense components which lead to a net income or loss for a time period.

Retained Earnings Statement

This statement tracks changes in retained earnings over a period; beginning balance, net income/loss, dividends, and ending balance are key components. Key information here includes changes in retained earnings that result from the performance within the financial position statements noted above.