Financial Statement Analysis Quiz

Financial Statement Analysis

• Financial statement analysis is the process of examining and interpreting financial statements to assess a company’s financial health and performance
• The analysis provides information about:
  • Profitability of the business entity
  • Ability to meet business obligations
  • Safety of investment in the business
  • Effectiveness of management in running the firm
• Common techniques include:
  • Vertical analysis
  • Horizontal analysis (trend or index analysis)
  • Financial ratios
  • Gross profit variance analysis
  • Cash flow analysis

Vertical Analysis

• Also known as common-size analysis and expresses each line item in a financial statement as a percentage of a base amount
• Typically total sales for the income statement and total assets for the balance sheet
• Useful tool for comparing financial statements of different companies or of the same company over time
• Expresses all line items as percentages, making it easier to see how the different components of a financial statement relate to each other and to identify trends over time
• Benefits:
  • Makes it easier to compare financial statements of different companies or of the same company over time
  • Helps to identify trends over time
  • Can help to identify areas where a company may be overspending or underperforming
• Drawbacks:
  • Can be difficult to interpret if the base amount is not chosen carefully
  • Does not take into account the absolute size of the company

Horizontal Analysis

• Compares financial statements of a company over time
• Calculates the percentage change in each line item from one period to the next
• Used to identify trends in a company’s financial performance
• Trend percentages: express the percentage change in each line item from one period to the next, relative to the base period (typically the first period being analyzed)
• Index analysis: expresses the percentage change in each line item from one period to the next, relative to a base value of 100
• Benefits:
  • Can be used to identify trends in a company’s financial performance
  • Can help to identify areas where a company may be overspending or underperforming
  • Can be used to compare the financial performance of a company to its peers or to industry standards
• Drawbacks:
  • Can be difficult to interpret if the base period is not chosen carefully
  • Does not take into account the absolute size of the company

Financial Ratios

• Compare a company’s financial performance to its peers or to industry standards
• Calculated by dividing one financial statement item by another
• Used to assess a company’s liquidity, solvency, activity, profitability, growth, and other aspects of its financial health

Types of Financial Ratios

Liquidity Ratios

• Measure a company’s ability to meet its short-term financial obligations
• Common liquidity ratios:
  • Current Ratio/Banker’s Ratio/Working Capital Ratio – primary test of liquidity to meet current obligations from current assets (Current Ratio = Current Assets / Current Liabilities)
  • Quick Ratio/Acid Test Ratio – measures the number of times the current liabilities could be paid with available cash and near-cash assets (e.g., cash, current receivables and marketable securities) (Quick Ratio = Quick Assets / Current Liabilities)

Activity/Efficiency Ratios

• Measure how efficiently a company is using its assets
• Common activity ratios:
  • Receivables Turnover – number of times that receivables are collected during the period (Accounts Receivable Turnover = Net Credit Sales / Average Receivables)
  • Average Age of Receivables/Average Collection Period/Days’ Sales in Receivables – average number of days during which the company must wait before receivables are collected (Average Age of Receivables = 360 or 365 days / Receivables Turnover)
  • Inventory Turnover – number of times that the inventory is replaced during the period (Inventory Turnover = Cost of Goods Sold / Average Inventory)
  • Average Age of Inventory/ Inventory Conversion Period /Days’ Sales in Inventory/Average Sales Period – average number of days during which the company must wait before the inventories are sold (Average Age of Inventory = 360 or 365 days / Inventory Turnover)
  • Average Age of Trade Payables/Payable Deferral Period/Days’ Purchases in Payables – length of time during which payables remain unpaid (Average Age of Trade Payables = 360 or 365 days / Payables Turnover)
  • Current Assets Turnover – movement and utilization of current assets to meet operating requirements (Current Assets Turnover = Cost of Goods Sold + Cash Operating Expenses Related to Current Assets / Average Current Assets)
  • Operating Cycle (Calculated by adding average age of inventory and average age of receivables)

Leverage/Solvency Ratios

• Measure the extent of a firm’s financing, with debt relative to equity and its ability to cover interest and other fixed charges such as rent and sinking fund contributions
• Additionally, these ratios measure the ability of the enterprise to survive over a long period of time
• Common solvency ratios:
  • Times Interest Earned – determines the extent to which operations cover interest expense (Times Interest Earned = EBIT / Interest Expense)
  • Debt-Equity Ratio – proportion of assets provided by creditors compared to that provided by shareholders (Debt-Equity Ratio = Total Liabilities / Total Shareholders’ Equity)
  • Debt Ratio – proportion of assets provided by creditors (Debt Ratio = Total Liabilities / Total Assets)
  • Equity Ratio – proportion of assets provided by shareholders (Equity Ratio = Total Shareholders’ Equity / Total Assets)
  • Financial Leverage – acquiring assets with funds at a fixed rate of interest or dividend (Positive Financial Leverage if Return on Assets > Fixed Rate of Return on Borrowed Funds; Negative Financial Leverage if Return on Assets < Fixed Rate of Return on Borrowed Funds)

Profitability Ratios

• Measure the overall performance of the firm and its efficiency managing assets, liabilities, and owners’ equity
• Common profitability ratios:
  • Return on Sales – portion of sales that went into company’s earnings (Return on Sales = Net Income / Net Sales)
  • Return on Assets – efficiency with which assets are used to operate the business (Return on Assets – operational performance = EBIT / Average Total Assets or Net Income + after-tax interest / Average Total Assets)
  • Return on Equity – amount earned on the owners’ or shareholders’ investment (Return on Equity = Net Income / Average Equity)
  • Earnings Per Share (EPS) – amount of net income earned by each ordinary share (EPS = Net Income – Preferred Dividends / Weighted Average Ordinary Shares Outstanding)

Market Ratios

• Type of financial ratio that compares a company’s stock price to its financial performance
• Used to assess a company’s valuation and to compare its stock price to the stock prices of its peers
• Common market ratios:
  • Price-Earnings (P/E) Ratio – number of pesos required to buy P1 or earnings (P/E Ratio = Price Per Share / Earnings Per Share)
  • Dividend Yield Ratio – rate of return in the investor’s Ordinary Share/ordinary share investments (Dividend Yield = Dividend Per Share / Price Per Share)
  • Dividend Pay-Out Ratio – proportion of earnings distributed as dividends (Dividend Pay-Out = Common Dividend Per Share / Earnings Per Share)

Other Meaningful Ratios:

• Fixed Assets to Total Equity Ratio – proportion of fixed assets to shareholders’ equity (Fixed Assets to Total Equity Ratio = Fixed Assets / Total Equity)
• Fixed Assets to Total Assets Ration – possible over-expansion of plant and equipment (Fixed Assets to Total Assets Ratio = Fixed Assets / Total Assets)
• Sales to Fixed Assets Ratio/ Plant Turnover – efficiency of management in keeping plant assets employed (Sales to Fixed Assets Ratio = Net Sales / Net Fixed Assets)
• Book Value Per Share - Ordinary Share – recoverable amount by Ordinary Shareholders in the event of liquidation if assets are realized at their book values (Book Value Per Share - Ordinary Share = Ordinary Shareholders’ Equity / Common Shares Outstanding)
• Times Preferred Dividend Earned – ability to provide dividends to preferred stockholders (Times Preferred Dividend Earned = Net Income After Taxes / Preferred Dividends)
• Capital Intensity Ratio – efficiency of the firm to generate sales through employment of its resources (Capital Intensity Ratio = Total Assets / Net Sales)
• Times Fixed Charges Earned – ability to meet fixed charges (Times Fixed Charges Earned = Net Income Before Taxes and Fixed Charges / Fixed Charges + Sinking Fund Payments)
• Working Capital Turnover – adequacy of working capital to support operation (sales) (Working Capital Turnover = Net Sales / Average Working Capital)
• Defensive Interval Ratio – coverage of current liabilities (Defensive Interval Ratio = Current Liabilities / Cash and Cash Equivalent)
• Payable Turnover – efficiency of the company in meeting the accounts payable (Payable Turnover = Net Purchases / Average Accounts Payable)
• Fixed Assets to Long-term Liabilities Ratio – extent of the utilization of resources from long-term debt (Fixed Assets to Long-term Liabilities Ratio = Fixed Assets / Long-term Liabilities)
• Rate of Return on Average Current Asset – profitability of current assets invested (Rate of Return on Average Current Asset = Net Income / Average Current Assets)
• Operating Profit Margin – profit generated after consideration of operating costs (Operating Profit Margin = Operating Profit / Net Sales)
• Cash Flow Margin – ability of the firm to translate sales to cash (Cash Flow Margin = Operating Cash Flow / Net Sales)

Cash flow analysis

• Assesses a company’s financial health by examining its cash flows
• Cash flow is the lifeblood of any business
• Free cash flow is a measure of a company’s ability to generate cash after taking into account its operating, investing, and financing activities
• Free cash flow shows how much cash the company has available to invest in its business or to return to its shareholders
• Free cash flow = NI + NCC + [Int ×(1 − tax rate)] − FCInv − WCInv
  • NI = net income
  • NCC = non cash charges (e.g., depreciation and change in deferred taxes)
  • Int = interest expense
  • FCInv = fixed capital investment (capital expenditures)
  • WCInv = working capital investment

Gross profit variance analysis

• Identifies the factors that have caused changes in a company’s gross profit
• Valuable tool for managers to understand how their company is performing and to make informed decisions about pricing, cost control, and production volume
• Three main factors that can affect a company’s gross profit:
  • Price – can change due to a number of factors, such as changes in demand, changes in competition, or changes in the cost of materials
  • Cost – can change due to a number of factors, such as changes in the cost of materials, changes in wages, or changes in overhead
  • Volume – can change due to a number of factors, such as changes in demand, changes in marketing, or changes in the economy
• Gross profit variances can be due to:
  • Change in selling price (Sales price variance)
  • Change in unit cost (Cost price variance)
  • Change in sales volume (Volume variance)

Additional Funds Needed (AFN)

• Amount of money that a company must raise from external sources to finance the increase in assets needed to support an increase in sales
• Also known as external financing needed
• Assumes that the company’s financial ratios do not change
• In response to an increase in sales, a company must increase its assets (e.g., PPE, inventories, accounts receivable, etc.)
• Part of this increase is offset by spontaneous increase in liabilities (e.g., accounts payable, taxes, etc.) and part is offset by increase in retained earnings
• AFN = Increase in Assets – Spontaneous Increase in Liabilities – Increase in Retained Earnings
  • Increase in Assets = Current level of assets × sales growth rate
  • Spontaneous Increase in Liabilities = Current level of liabilities × sales growth rate
  • Increase in Retained Earnings = New level of sales × profit margin × retention ratio
• A negative figure AFN means that there is a surplus of capital.