FINMAN-2-2-ppts-compiled.docx

**FINMAN 2 -- FINANCIAL STATEMENTS ANALYSIS** - **Financial Statements** - are structured representation of the financial position of and the transactions undertaken by an enterprise. - They provide information about the entity's economic resources and the claims against the report...

**FINMAN 2 -- FINANCIAL STATEMENTS ANALYSIS** - **Financial Statements** - are structured representation of the financial position of and the transactions undertaken by an enterprise. - They provide information about the entity's economic resources and the claims against the reporting entity, as well as the effects of transactions and other events that change a reporting entity's economic resources and claims. - **OBJECTIVE**: to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity. (Conceptual Framework, IASB, September 2010) - **Basic Financial Statements:** - Balance Sheet (Statement of Financial Position) - Income Statement (Statement of Comprehensive Income) - Statement of Shareholders' Equity - Statement of Cash Flows - Notes to the Financial Statement - **Financial Statement Analysis -** is the process of extracting information from financial statements to better understand a company's current and future performance and financial condition. - It involves: - Comparing the firm's performance to that of other firms in the same industry (cross-sectional analysis), and - Evaluating trends in the firm's financial position over time (time-series analysis). - **OBJECTIVE**: to identify an organization's financial strengths and weaknesses. **LIMITATIONS OF FINANCIAL STATEMENTS ANALYSIS:** - Information derived by the analysis are not absolute measures of performance in any and all of the areas of business operations. They are only indicators of degrees of profitability and financial strength of the firm. - There are inherent limitations in the accounting data which the analyst is working with brought about by (a) variation and lack of consistency in the application of accounting principles, policies and procedures, (b) too condensed presentation of data, and (c) failure to reflect change in purchasing power. - Performance measures or tools and techniques (Quantitative Measurements) are not absolute measures but should be interpreted relative to the nature of the business and in the light of past, current and future operations. - Analysts should be alert to the potential for management to influence the outcome of financial statements in order to appeal creditors, investors and other stakeholders. **STEPS IN ANALYZING FINANCIAL STATEMENTS:** 1. Establish objectives of the analysis. 2. Study the industry in which firm operates and relate industry climate to current and projected economic development. 3. Develop knowledge of the firm and quality of management. 4. Evaluate financial statements using any of the techniques below: 1. Horizontal Analysis/Index Analysis 2. Vertical Analysis 3. Financial Ratios 5. Summarize findings based on analysis and reach conclusions about firm relevant to the established objectives. - **Horizontal analysis --** is a percentage analysis of changes in comparative financial statements. **Steps in conducting horizontal analysis:** 1. Compute the peso amount of the change from the base (earlier) period to the later period, and 2. Divide the peso amount of change by the base-period amount. This, however, is not done if the base year figure is negative or zero. - **Vertical Analysis --** is a percentage analysis used to show the relationship of each component to the base total within a single statement. - **Common Size Financial Statements --** are statements which amounts were translated from peso amounts to percentages, indicating the relative sizes of an item in proportion to the whole. - Thus, common size balance sheet shows assets, liabilities and equity as a percentage of total assets, while common size income statements express revenue and expenses as a percentage of sales. **Conversion Procedures** - For the balance sheet, each item therein is converted to percentage by dividing it by total assets. - In income statement, each item is restated as a percentage of net sales by dividing the former by the latter. **INTERPRETATION** GUIDELINES -- **BALANCE** SHEET - A common-size balance sheet shows the percent of total assets that has been invested in each type or kind of assets. These percentages may be compared with those of a competitor or the industry to determine whether or not the firm has over- or underinvested in one or more assets. - The common-size statement will also show the distribution of liabilities and equity, i.e., the source of capital invested in the assets. - The percentage of current assets may also be related to the percentage of current liabilities to determine the liquidity of the company. **INTERPRETATION** GUIDELINES -- **INCOME** STATEMENT - The common-size income statement shows the amount or percentage of the sales that has been absorbed by each individual cost or expense item and the percentage that remains as net income. - Comparison of year-to-year income statement common-size ratios will show whether a larger or smaller relative amount of net sales was used to meet particular costs or expenses. - Comparison of the gross profit percentage from year-to-year may also reveal success or failure efficiency in the procurement and merchandising policies. **FINMAN 2 -- FINANCIAL RATIOS** - **Financial Ratio --** is a comparison in fraction, proportion, decimal or percentage form of two significant figures taken from financial statements. - It expresses the direct relationship between two or more quantities in the statement of financial position or statement of comprehensive income. - It involves methods of calculating and interpreting financial ratios to analyze and monitor the firm's performance. **USES OF FINANCIAL RATIOS -- WITHIN THE FIRM** - Identify deficiencies in a firm's performance and take corrective action. - Evaluate employee performance and determine incentive compensation. - Compare the financial performance of the firm's different divisions. - Prepare, at both firm and division levels, financial projections. - Understand the financial performance of the firm's competitors. - Evaluate the financial condition of a major supplier. **USES OF FINANCIAL RATIOS -- OUTSIDE THE FIRM** - **Financial ratios** are used by: - Lenders in deciding whether or not to lend to a company. - Credit-rating agencies in determining a firm's credit worthiness. - Investors (shareholders and bondholders) in deciding whether or not to invest in a company. - Major suppliers in deciding to whether or not to extend credit to a company and/or in designing the specific credit terms. **CAUTIONS IN USING FINANCIAL RATIO ANALYSIS** - - - - - - - - - - **CATEGORIES OF FINANCIAL RATIO (PAL2MF)** - Liquidity Ratio - Activity Ratio - Leverage Ratio - Profitability Ratio - Market Ratios **LIQUIDITY RATIO** - **Liquidity Ratio --** measures the firm's ability to pay off debts maturing within a year or within the next operating cycle. - **Basic Liquidity Ratios:** - **Current Ratio --** measures the firm's ability to meet its short-term obligations. It is the primary test of solvency to meet current obligations using current assets as a going concern, and it measures the adequacy of working capital. - Formula: \ [\$\$Current\\ Ratio = \\ \\frac{\\text{Current\~Assets}}{\\text{Current\~Liabilities}}\$\$]{.math.display}\ - **Quick (Acid Test) Ratio --** measures the firm's ability to meet its short-term obligations using its "quick" assets. It severely tests the company's immediate ability to be solvent/liquid. - Formula: \ [\$\$Quick\\ (Acid\\ Test)\\ Ratio = \\ \\frac{Cash + Marketable\\ Securities + Accounts\\ Receivables}{\\text{Current\~Liabilities}}\$\$]{.math.display}\ - **Defensive Interval Ratio --** measures the length of time in days the firm can operate on its present liquid resources - Formula: \ [\$\$Defensive\\ Interval\\ Ratio = \\ \\frac{Cash + Marketable\\ Securities + Accounts\\ Receivables}{\\text{Average\~Daily\~Operating\~Expenses}}\$\$]{.math.display}\ - FINANCIAL RATIOS **ACTIVITY RATIO** - **Activity Ratio --** measures the efficiency of the company in converting its resources into sales or cash (operations). - Basic Activity Ratios: - - \ [\$\$\\ A/R\\ Turnover\\ = \\ \\frac{\\text{Net\~}\\left( \\text{Credit} \\right)\\text{\~Sales}}{Average\\ Accounts\\ Receivable\*}\$\$]{.math.display}\ \ [\$\$\*Average\\ Accounts\\ Receivable = \\ \\frac{A/R,\\ Beg + A/R,\\ End}{2}\$\$]{.math.display}\ - - \ [\$\$\\text{\~Days\~Sales\~}\\text{Out.}\\ = \\ \\frac{\\\#\\text{\~of\~Days\~in\~a\~Yr}.}{\\text{AR\~Turnover}}\\text{\~or\~}\\frac{\\text{Av}\\text{g.}\\text{\~AR}}{\\text{Av}\\text{g.}\\ Daily\\ Net\\ Sales\\ \*}\$\$]{.math.display}\ \ [\$\$\*Average\\ Daily\\ Net\\ \\left( \\text{Credit} \\right)\\ Sales = \\ \\frac{\\text{Net\~Credit\~Sales}}{\\text{Number\~of\~Days\~in\~a\~Year}}\$\$]{.math.display}\ - **Inventory Turnover Ratio --** measures the firm's efficiency in managing and selling its inventories. This ratio indicates if a firm holds excessive stocks of inventories that are unproductive and that lessens the company's profitability. - Formula: \ [\$\$\\ Inventory\\ Turnover\\ = \\ \\frac{\\text{Cost\~of\~Sales}}{Average\\ Inventory\*}\$\$]{.math.display}\ \ [\$\$\*Average\\ Inventory = \\ \\frac{Invty,\\ Beg + Invty,\\ End}{2}\$\$]{.math.display}\ - **Days Supply in Inventory (also called as Average Age of Inventory)--** measures the average number of days to sell or consume the average inventory. - Formula: \ [\$\$\\text{\~Days\~Supply\~in\~}\\text{INV.}\\ = \\ \\frac{\\\#\\text{\~of\~Days\~in\~a\~}\\text{yr.}}{\\text{Inv}.\\text{\~Turnover}}\\text{\~or\~}\\frac{\\text{Av}\\text{g.}\\text{\~Inventory}}{\\text{Av}\\text{g.}\\ Daily\\ COS\\ \*}\$\$]{.math.display}\ \ [\$\$\*Average\\ Daily\\ Cost\\ of\\ Sales = \\ \\frac{\\text{Cost\~of\~Sales}}{\\text{Number\~of\~Days\~in\~a\~Year}}\$\$]{.math.display}\ - **Accounts Payable Turnover Ratio --** measures the firm's efficiency in meeting its accounts payable. - Formula: \ [\$\$Accounts\\ Payable\\ Turnover\\ = \\ \\frac{\\text{Net\~}\\left( \\text{Credit} \\right)\\text{\~Purchases}}{Average\\ Accounts\\ Payable\*}\$\$]{.math.display}\ \ [\$\$\*Average\\ Accounts\\ Payable = \\ \\frac{AP,\\ Beg + AP,\\ End}{2}\$\$]{.math.display}\ - **Average Payment Period (also called as Average Age of Payables)--** measures the average number of days a company pays its accounts payable. It determines whether the company is paying its invoices on a timely basis. It is used to evaluate the company's payment policies. - Formula: \ [\$\$\\ Ave.\\ Payment\\ Period\\ = \\ \\frac{\\\#\\text{\~of\~Days\~in\~a\~Year}}{\\text{AP\~Turnover}}\\text{\~or\~}\\frac{\\text{Av}\\text{g.}\\text{\~AP}}{Ave.\\ Daily\\ Net\\ Purchases\\ \*}\$\$]{.math.display}\ \ [\$\$\*Average\\ Daily\\ Net\\ \\left( \\text{Credit} \\right)\\ Purchases = \\ \\frac{\\text{Net\~Credit\~Purchases}}{\\text{Number\~of\~Days\~in\~a\~Year}}\$\$]{.math.display}\ - **Plant/Fixed Asset Turnover Ratio --** measures the level of use of property, plant and equipment in operations. It is used to test roughly the efficiency of management in keeping plant properties employed. - Formula: \ [\$\$Plant/Fixed\\ Asset\\ Turnover\\ = \\ \\frac{\\text{Net\~Sales}}{Average\\ Fixed\\ Assets\*}\$\$]{.math.display}\ \ [\$\$\*Average\\ Fixed\\ Assets = \\ \\frac{Fixed\\ Assets,\\ Beg + Fixed\\ Assets,\\ End}{2}\$\$]{.math.display}\ - **Investment/Asset Turnover Ratio --** measures the firm's efficiency in using its available resources (assets) to generate sales. - Formula: \ [\$\$Plant/Fixed\\ Asset\\ Turnover\\ = \\ \\frac{\\text{Net\~Sales}}{Average\\ Total\\ Assets\*}\$\$]{.math.display}\ \ [\$\$\*Average\\ Total\\ Assets = \\ \\frac{Total\\ Assets,\\ Beg + Total\\ Assets,\\ End}{2}\$\$]{.math.display}\ - **Capital Intensity Ratio --** measures the intensity of the company's use of investment to generate revenue for the company. - Formula: \ [\$\$Capital\\ Intensity\\ Ratio\\ = \\ \\frac{\\text{Average\~Total\~Assets}}{\\text{Net\~Sales}}\$\$]{.math.display}\ LEVERAGE RATIO - **Leverage Ratio --** measures how risky the firm is, the degree of use of debt facilities to finance resources and operations, and the company's solvency. - Basic Leverage Ratios: - **Debt Ratio --** measures the proportion of total assets financed with debt. - Formula: \ [\$\$\\ Debt\\ Ratio\\ = \\ \\frac{\\text{Total\~Liabilities}}{\\text{Total\~Assets}}\$\$]{.math.display}\ - **Equity Ratio --** measures the proportion of total assets financed with equity. - Formula: \ [\$\$\\ Equity\\ Ratio\\ = \\ \\frac{\\text{Total\~Shareholder}s\^{\'}\\text{Equity}}{\\text{Total\~Assets}}\\ or\\ 1\\ - Debt\\ Ratio\$\$]{.math.display}\ - **Debt to Equity Ratio --** measures debt relative to amounts of resources provided by owners. It provides a comparison of percentage of resources provided by the creditors against those provided by the business owners. - Formula: \ [\$\$\\ Debt\\ to\\ Equity\\ Ratio\\ = \\ \\frac{\\text{Total\~Liabilities}}{\\text{Total\~Shareholder}s\^{\'}\\text{Equity}}\$\$]{.math.display}\ - **Times Interest Earned Ratio --** measures the firm's ability to make contractual interest payments. It measures how many times interest expense is covered by operating profit. - Formula: \ [\$\$\\ Times\\ Interest\\ Earned\\ Ratio\\ = \\ \\frac{Operating\\ Profit/EBIT}{\\text{Interest\~Expense}}\$\$]{.math.display}\ - **Fixed Payment Coverage Ratio --** measures the firm's ability to meet all fixed payment obligations. This simply expands the coverage of times interest earned ratio by including other fixed payments. - **Fixed charges --** defined as payments other than interest expenses that have fixed determinable payments on a periodic basis (e.g. Lease payments, sinking bond payments). - Formula: \ [\$\$\\ Fixed\\ Payment\\ Coverage\\ Ratio\\ = \\ \\frac{Operating\\ Profit + Fixed\\ Charges}{Interest\\ Expense + Fixed\\ Charges}\$\$]{.math.display}\ - **Financial Leverage Multiplier (Equity Multiplier) --** measures the extent to which the company uses debt in financing asset investment. - Formula: \ [\$\$\\ Financial\\ Leverage\\ Multiplier\\ = \\ \\frac{\\left( \\text{Average} \\right)\\text{Assets}}{\\left( \\text{Average} \\right)\\text{Equity}}\$\$]{.math.display}\ - **Operating Leverage Factor (Degree of Operating Leverage) --** measures the extent to which a company uses fixed costs in its cost structure. It also a measure of the risk of profitability of an entity given the volatility of sales volume. - Formula: \ [\$\$\\ Operating\\ Leverage\\ Factor\\ = \\ \\frac{\\text{Contribution\~Marging}}{\\text{Operating\~Profit}}\$\$]{.math.display}\ PROFITABILITY RATIO - **Profitability Ratio --** measures how profitable the company is in its operations and usage of resources. - Basic Profitability Ratios: - **Gross Profit Margin --** measures the proportion of earnings to the sales after the cost of sales were paid. - Formula: \ [\$\$\\ Gross\\ Profit\\ Margin\\ = \\ \\frac{\\text{Gross\~Profit}}{\\text{Net\~Sales}}\$\$]{.math.display}\ - **Operating Profit Margin --** measures the proportion of earnings to the sales after all costs expenses other than interest and taxes were paid. - Formula: \ [\$\$\\ Operating\\ Profit\\ Margin\\ = \\ \\frac{\\text{Operating\~Profit}}{\\text{Net\~Sales}}\$\$]{.math.display}\ - **Net Profit Margin --** measures the proportion of earnings to the sales after all costs expenses were paid. - Formula: \ [\$\$\\ Net\\ Profit\\ Margin\\ = \\ \\frac{\\text{Net\~Profit}}{\\text{Net\~Sales}}\$\$]{.math.display}\ - **Earnings Per Share --** measures the peso return on each ordinary share. It reflects the company's earning power, i.e. its ability to generate profit from normal operations. - Formula: \ [\$\$\\ Earnings\\ Per\\ Share\\ = \\ \\frac{\\text{Net\~Profit\~Attributable\~to\~Common\~Stockholders}}{\\text{Average\~Common\~Stock\~Outstanding}}\$\$]{.math.display}\ - **Return on Investment (or Return on Asset) --** measures the overall effectiveness of the management in generating profits with its available assets. This ratio indicates whether the management is using the available funds or investment wisely in the operations - Formula: \ [\$\$\\ Return\\ on\\ Investment\\ = \\ \\frac{\\text{Net\~Profit}}{\\text{Average\~Total\~Assets}}\$\$]{.math.display}\ OR \ [*Return* *on* *Investment* = *Asset* *Turnover* *X* *Net* *Profit* *Margin*]{.math.display}\ - **Return on Equity -- measures the return earned on the shareholders' investment in the firm.** - Formula: \ [\$\$\\ Return\\ on\\ Equity\\ = \\ \\frac{\\text{Net\~Profit}}{\\text{Average\~Ordinary\~Equity}}\$\$]{.math.display}\ OR \ [*Return* *on* *Equity* = *Return* *on* *Investment* *X* *Financial* *Leverage* *Ratio*\*]{.math.display}\ ^\*^[\$Financial\\ Leverage\\ Ratio = \\ \\frac{\\text{Average\~Total\~Asset}}{\\text{Average\~Ordinary\~Equity}}\$]{.math.inline} MARKET RATIO - **Market Ratio --** relates the firm's market value, as measured by its current share price, to certain accounting values. It gives insight into how investors in the marketplace feel the firm is doing in terms of risk and return. - Basic Market Ratios: - **Price/Earnings Ratio --** measures the amount that investors are willing to pay for each dollar of a firm's earnings. The level of this ratio indicates the degree of confidence of the investors in the company's future performance. - Formula: \ [\$\$\\ Price/Earnings\\ Ratio = \\ \\frac{\\text{Market\~Price\~Per\~Share}}{\\text{Earnings\~Per\~Share}}\$\$]{.math.display}\ - **Market/Book Ratio --** provides an assessment of how investors view the firm's performance. It relates the market value of the firm's share to its book value. - Formula: \ [\$\$\\ Market/Book\\ Ratio\\ = \\ \\frac{\\text{Market\~Price\~per\~Share}}{\\text{Book\~Value\~per\~Share}}\$\$]{.math.display}\ - **Dividend Yield Ratio --** shows the rate earned by shareholders from dividend relative to current price of stock. - Formula: \ [\$\$\\ Dividend\\ Yield\\ Ratio\\ = \\ \\frac{\\text{Dividend\~per\~Share}}{\\text{Market\~Price\~per\~Share}}\$\$]{.math.display}\ - **Dividend Payout Ratio --** shows the percentage of earnings paid to shareholders. - Formula: \ [\$\$\\ Dividend\\ Payout\\ Ratio\\ = \\ \\frac{\\text{Dividend\~per\~Share}}{\\text{Earnings\~per\~Share}}\$\$]{.math.display}\ **DUPONT SYSTEM OF ANALYSIS** - **DuPont System of Analysis** -- used to dissect the firm's financial statements and to assess its financial condition. - It **[merges]** the income statement and balance sheet into two summary measures of profitability, the **ROA** and the **ROE**. - The DuPont system first brings together the net profit margin, which measures the firm's profitability on sales, with its total asset turnover, which indicates how efficiently the firm has used its assets to generate sales. \ [*ROI* = *Net* *Profit* *Margin* *X* *Total* *Asset* *Turnover*]{.math.display}\ - The modified DuPont Formula relates the firm's return on total assets to its return on common equity. The latter is calculated by multiplying the return on total assets (ROA) by the financial leverage multiplier (FLM) \ [*ROE* = *Return* *on* *Investment* *X* *Financial* *Leverage* *Multiplier*]{.math.display}\