Financial Statement Analysis And Managerial Accounting UCSC PDF
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UCSC
Martina Marazzi
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This document details financial statement analysis and managerial accounting concepts, including accrued liabilities, deposits, unearned revenues, and provisions, as well as contingent liabilities. It discusses valuing long-term liabilities, reporting bonds, and the time value of money. It also explores bond vocabulary and calculations and discusses common-size financial statements and horizontal analysis, among other topics.
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lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng UCSC | Marna Marazzi – – – – – – – – – Accrued liabilies or accrued expenses (when somebody uses resources which have not been built or invoiced or paid yet) Deposits Unearned revenues (somebody pays for a service which ha...
lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng UCSC | Marna Marazzi – – – – – – – – – Accrued liabilies or accrued expenses (when somebody uses resources which have not been built or invoiced or paid yet) Deposits Unearned revenues (somebody pays for a service which has not been delivered yet, so the cash comes in, but the service has not been delivered) Payroll-related liabilies (company pays a salary to the employee but is also obliged to pay a percentage of the salary to INPS, for example, for social contribuon) Sales tax payable (=VAT payable) Tax payable Provisions Notes payable – Short term Debt – Current poron of long-term debts Provisions Provisions (fondi for future expenses and risks) of uncertain me and amount – warranes – Liabilies of uncertain ming and amount (we don’t know how much it will cost to repair and we don’t when this will happen) – Covered under IAS 37—Provisions, Conngent Assets and Conngent Liabilies – Examples include Warranty: companies may guarantee their products under a warranty – Matching principle demands the company records the warranty expense in the same period the business records sales revenue Conngent liabilies – A potenal liability that depends on the future outcome of past events (they originate in the past and we may see them in the future) • Possible obligaon to be conrmed by a future event • Present obligaon that may/may not require oulow of resources • Reliable esmate of amount of present obligaon cannot be made – Examples: future liabilies that may arise due to lawsuits, tax disputes, or alleged violaons of environmental protecon laws – Either: accrue (supposed to have a tax ligaon that we don’t know how it is going to end, but the IRS has already computed the value of taxaon + ne that they are asking because of miscalculaon, so in that case we want to be very prudent and we put it under conngent liability and we put also the amount), disclose (means that we don’t put in the amount but we disclose it in the set of nancial statements), or neither. – Can be overlooked when creang a Balance Sheet as they aren’t actual debts – Net income will be overstated if the company fails to accrue interest on liability Valuing (and reporng) long-term liabilies Reporng bonds – Time value of money: means that if we have €1 today and €1 in ten years is not the same thing, and it is beer to have it today because in ten years this €1 invested today can become a higher value, so we have a present value, that is the value of the money today and a future value, which is the value of the money in the x amount of years When we talk about liabilies, we talk about obligaons, that are what we owe to other enes and therefore if we have to value the obligaon, we need to take into account the me value of money. One example of long-term obligaon that is listed under the liability side (long-term but also has a poron on the short-term) are actually the bonds, which are a promise to repay a bond in a certain amount of year and also include a payment of a period interest. 14 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng UCSC | Marna Marazzi Some vocabulary about bonds: • The maturity of the bond is the expiraon of the bond, so the me when the bond holder will be refunded • The coupon rate: the coupon is the periodic payment of the interest, so the coupon rate is the rate of interest which is paid periodically to the bond holder • The nominal (or face) value of the bond is what will be paid back to the bond holder at maturity • The market interest rate means that there is an interest rate that is determined on the market every day and depends on many factors, such as depending on risk this market rate uctuates in general, and specically from company to company So, the market rate is volale, while the nominal (or coupon) rate is xed for all the life of the bond. – Aects the pricing of bonds (valuaon of bonds) – Bond interest rates determine bond prices • Always sold at market price (bond’s present value) • Stated interest rate (coupon rate) • Market interest rate (eecve interest rate) We know that we have to report bonds at the net present value of the bond since it is a long-term obligaon (being a long-term obligaon means that the criterium to report the value of the bond on the Balance Sheet is the present value). – Bonds may be issues at par, at discount, at premium and the two numbers that we compare to determine how the bond is issued are the proceeds from issuance of the bond (amount of money that the company will get when it issues then bond) vs the face value • At par: coupon rate = market rate proceeds = face value (the promise that you make as a company that is issuing a bond to your bond holder is that you will pay on this loan an interest which is exactly equivalent to the market rate) • At discount: coupon rate < market rate proceeds < face value (if you want to sell the bond, as a company, you have to give a discount, so you will say that today you will be giving me less money than expected to compensate this dierence, because otherwise why should I buy your bond?) • At premium: coupon rate > market rate proceeds > face value How do we compute the present value of the bond obligaon? The assumpon is that the bond is issued at par, the nominal value (or face value) is 1000, the coupon interest rate is 5% and also the market interest rate is 5% and we have a semiannual payment. What we have to do in order to compute the present value of this bond at issuance is to basically sketch out the cash ow (what is this obligaon implying to us), and the cash ow is set up of 2 components: 1. The rst component is the payment of 1000 at maturity 2. Several payments of equal amount every 6 month and to determine the equal amount that needs to be paid every six months we have to mulply 1000 for the coupon interest rate and divide it by 2 since it is a semiannual payment, so , so every 6 month we have to pay 25 and we have to pay 25 for 10 mes. So, we have to report these two ows at present value, and we so have to decide when the present value is (could be present value at me 0, at me 1, etc …). With regards to the rst cash ow (payment of 1000 at maturity) we know that the present value of 1000 will be less than 1000, so we discount the 1000 up to today (the obligaon is in 5 years but today this obligaon is worth less on a value term) and to know how much less we have to look at the market rate. 15 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng UCSC | Marna Marazzi With regard to the second ow, we have the same problem as before, that is to know what is worth today ten payments delayed in ve years, each one of 25, so it is the present value of an annuity (rendita) for ten periods at 5%. Basically, we have a payment in ve years and then ten semiannual payments, so the value of the bond today is the value discounted of this capital payment in ve years (face value payment at maturity) and the ten consecuve payments over ve years’ me when the market would grant 5% on that amount of money (we have to think at what we are giving up lending this money and not invesng it in another investment). The present value can be computed at me 0, and this is called the proceed from issuance or it can be computed at each point in me and at each point in me of course the present value would adjust (so if we are at issuance we say ve years and ten payments, but if we are posioned at me 1 we say that the payment is in four years and the payments are not ten, but 8), this is why the value of the bond changes over the life of the bond. So, if we are issuing a bond at par, the present value at maturity is exactly the nominal value. Take home – Liabilies are classied in: • Short-term and long-term depending on expiraon date • Denite or un-denite in the amount • Certain or conngent – Liabilies are reported at their nominal value if they are short-term, of denite amount and certain – Liabilies are reported at their present value if they are long-term, of denite amount and certain – Liabilies of undene amount need to be esmated – Conngent liabilies are typically disclosed in the notes We have seen how to evaluate bonds, that is at net present value, which means whatever the long-term obligaon we are dealing with is we have to do two things: – Idenfy the future cash oulow that the obligaon implies – Discount this cash ow at present value and then we have to report this. With reference to bonds there are 4 issues / items that we need to consider: – Amount of money (cash) at issuance, which is called the proceeds (present value of the bond at issuance) and it can be equal, above of below the face value of the bond, and so we have bonds issued at par at premium or at discount – How do we determine the interest expense? It is determined using the eecve market rate in place at issuance, so if the bond is issued at par the market rate is equal to the coupon rate (in this specic case the cash payment to the bond holder coincides with the interest expense), when the bond is issued at discount or at premium things are dierent (look at the table), but in any case the interest expense remains equal to the present value of the bond * market rate in place when we issue the bond – In case of issued at premium or bond issued at premium how do we amorze the discount on bond or the premium on bond, and in any case this amorzaon which applies both to the discount and the premium follows the eecve interest rate method, that is to say amorzaon is determined using the algebraical sum of the interest expense and the cash payment (that is the amount that we have to use to amorze the discount or the premium) – What is the amount of payment that is due at maturity? The payment at maturity, regardless that it is premium, discount or par is always equal to the face value CASH FLOW STATEMENT PREPARATION 16 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng UCSC | Marna Marazzi Denion and purposes The Statement of Cash Flow provides a thorough explanaon of the change occurred in a rm’s cash* (cash and cash equivalents) balance during the enre accounng period. Cash inows and oulows are grouped according to the type of acvity that generate them: – Operaons: cash inows and oulows concerned with ordinary funconing of the enterprise – Invesng: cash inows and oulows concerned with transacons to acquire or to dispose of long-lived assets – Financing: cash inows and oulows concerned with geng cash or repaying debt We could create a Cash Flow Statement simply looking at the cash column and labelling each cash inow and oulow as cash ow from operaon, from invesng or from nancing (direct method). The point is that this easy way to prepare the Cash Flow Statement is not what is implemented in 99,9% of the companies, since companies use another method called the indirect method. We need an indirect method because at some point in me somebody said that we have an income generated that is reported using the accrual basis ( accrual basis means that if we report revenues, we’re not waing to get paid and if we report expenses we don’t wait to pay), so we start seeing that revenues and expenses deviate from cash inow and oulow and so at some point both statements are referred to ow value (revenues is a ow value and expenses is a ow value, cash inow and cash oulow are both ow values). Somebody wondered why we don’t reconcile the income posion to the cash posion, so why don’t we nd a way to start with income and then idenfy which poron of that income is also cash ow (how is it possible that I have a income but no cash in hand or how is it possible that I have a loss but has money in hand? The cash ow and the earnings ow are not coinciding). So, the Cash Flow Statement prepared using the indirect method suggests an answer to this queson: it is the reconciliaon of income posion to cash posion. Preparaon of Cash Flow Statement - indirect method 1. The beginning: the Balance Sheet equaon ASSET = LIABILITY + EQUITY 2. The connuaon: the re-classicaon of the Balance Sheet equaon Cash + Non-cash Current assets + Long-lived Assets = Current Liabilies + Long-term Liabilies + Capital + Retained Earnings (Net Income – Dividends) 3. The focus on the cash: the “arrangement” of the Balance Sheet equaon Cash = Net Income – Non-cash Current Assets + Current Liabilies – Long-lived assets + Long-term Liabilies + Capital – Dividends 4. The change in cash: stac to dynamic Balance Sheet equaon Change in cash equal to change in all the other items, so Δ +/- Cash = – Net Income ** - Δ +/- Non-cash Current Assets + Δ +/- Current Liabilies (**Δ Retained Earnings = Net Income – Dividends) Cash ow from operaons – - Δ +/- Long-lived Assets Cash ow from invesng – + Δ +/- Long-term Liabilies + Δ +/- Capital – Dividends ** Cash ow from nancing 17 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng UCSC | Marna Marazzi Net Cash Flow This means that we want to observe the cash ow we can look at the cash ow changes on the le side (and this is what we were doing when preparing the cash ow for the transacon analysis) or, because this is an equaon that balances, we can look at the right side of the equaon because it is equivalent to the straight, direct change in cash. 99,9% of companies use the indirect method, so to determine the change in cash they look at the right side of the equaon because if we look at the right side of the equaon the rst input is income, and this allows to reconcile the income posion to the cash posion. Example: Assume year 1 Income Statement for a very simple service company that provides services for 100 and has got expenses for 60 (these are wages expenses because this company is providing clinic services and subcontracng to people). YEAR 1 YEAR 1 (beginning) YEAR 1 (end) Revenues 100 Accounts Receivable 1 0 Accounts Receivable Expenses 60 Wages Payable 5 Wages Payable Income 40 How much cash ew in this company over the period (what is the change of cash over the period)? + Income 40 Δ+ Accounts Receivable 10 Δ- Wages Payable Cash ow 5 35 2 0 1 0 Non-cash current Assets Current Liabilies When we have 100 in Revenues, this doesn’t mean that we collected all the Revenues and we can also have exisng Accounts Receivables that we may end up collecng during the period, so in order to say which poron of the Revenues is cash collecon from customers what we have to do is start saying we have Accounts Receivable at the beginning, we have sold during the period 100 but we may end up having Accounts Receivable at the end, which basically means take the poron of Income, Revenues, that is associated to Accounts Receivable and adjust for the change in Non-cash current Assets, in this case Accounts Receivable. In the example: the potenal collecon from customers is 110, but we are le with 20, which means we collected 90 (equal to Revenues – the change in Non-cash Current Assets). The same thing happens for Expenses, so similar procedure but in this case we talk about cash oulows. The complicaon comes from this: Net Income is our input in the rst secon, but we have to determine Cash Flow from Operaons. Do we include in Net Income items that are Non-operang? Because if we want to reconcile the boom of the Income Statement to the rst secon, which is Cash Flow from Operaon we say that everything that we write there as Cash Flow from Operaons has to be related to operaons. Adjustments: 1. So, basically one complicaon is to exclude Non-operang items, which means that if they are already computed in the calculaon of Net Income we have: – Add back them if they are Expenses (Non-operang) – Subtract them If they are Revenues (Non-operang) and one example are Gains or Losses on Sale of Equipment. 18 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng UCSC | Marna Marazzi 2. The second adjustment is to exclude Non-monetary items: – Add back them if they are Expenses (Non-monetary) – Subtract them If they are Revenues (Non-monetary) and one example are Depreciaon, Amorzaon, Impairment of Goodwill (they are examples that are considered in the calculaon of Net Income, but for any reason will ever convert into cash). 3. Third adjustment is due to the fact that we have me lags between the Revenue and the Expense item and the actual cash ow, so here we have to: – Add the changes in Current Liabilies – Subtract the changes in Non-cash current Assets So, basically there are three types of items that we have to amend: we have seen the third one and now we have to see others. But we have to remember that excluding one item from Net Income implies that we have to do some other adjustments somewhere in the system to be able to balance the system, since this is a system that works with the double entry (Balance Sheet equaon). Example: When we depreciate an item we always have to think about what happens: we include the Depreciaon Expense in Retained Earnings and we deduct the depreciaon either straight from the Long-lived assets or we add it to Accumulated Depreciaon, but in any case, the book value of the Long-lived Asset aer the applicaon of depreciaon is reducing. When we say that we take into account, if we start with Cash Flow from Operaon, that this depreciaon will never convert into cash oulow and adjust, it means that we are basically rewinding or redoing this transacon pung a + in the Retained Earnings’ column in order to exclude the depreciaon, but if we do that we have to balance this transacon and so we have also to add back the depreciaon to Long-lived Assets. This adjustment that we make to the Income and to the Long-lived Assets net are done using the doubleentry but don’t get journalized, so the accounng doesn’t get changed because of this – this are all extra accounng adjustments, but they are needed otherwise the numbers don’t come up right. Adjusng in this case (Depreciaon) means that it will aect both the Cash Flow from Operaons and the Cash Flow from Invesng (Long-lived Assets are in the Cash ow from Invesng) 19 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng UCSC | Marna Marazzi Preparaon of Cash Flow Statement - direct method We have already seen the preparaon of the Cash Flow Statement according to the direct method, but there is another way to work with the direct method and there is a dierence because, suppose that we don’t have the imput of the cash account, could we sll be able, with one Income Statement and two Balance Sheets, to work out the direct cash collecon from customers, payments to suppliers and payments of addional expenses? The answer is yes, but how? The idea is to start with the Income Statement and curve out from the Income Statement Cash Reeceipts from Customers and Cash Payments to Suppliers. Cash ows from operaons are comprised of four items: Cash receipts from customers Sales of current period + beginning period Accounts Receivable Cash potenally collecble during the year - end of period Accounts Receivable Cash receipts from customers Cash disbursements to suppliers Purchases + beginning period Accounts Payable Cash potenally payable during the year - end of period Accounts Payable Cash disbursements to suppliers Cash disbursements on operang expenses General expenses - beginning period Prepaid-Expenses + beginning period Expenses Payable Cash potenally payable during the year + ending Prepaid Expenses - ending Expenses Payable Cash disbursements on operang expenses Cash disbursements to tax authority Property Taxes + beginning period Property Taxes Payable Cash potenally payable during the year - end of period Property Taxes Payable Cash disbursements to tax authority 20 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng UCSC | Marna Marazzi FINANCIAL STATEMENT ANALYSIS Perform basic (horizontal and vercal) analysis of nancial statements – Horizontal Analysis The study of percentage changes from year to year is called horizontal analysis. Compung a percentage change takes two steps: • Compute amount of change from one period (base period) to the next • Divide the amount of change by the base-period amount Illustraon: Nestlé Nestlé’s sales increased by 0.77% during 2016, and operang prot increased by 6.08%, in 2016, computed as follows: Nestlé’s net sales increased by 0.77% during 2016, computed as follows: Step 1: Compute amount change 2016 2015 CHF 89,469 CHF 88,785 = Increase CHF 684 Step 2: Divide change by base-period amount Let’s apply this to Nestlé’s sales and operang prot for the year 2016 and 2015 (CHF 89,469 compared to CHF 88,785, and CHF 13,163 compared to CHF 12,408, respecvely). For sales, the amount change is an increase of CHF 684, and for operang prot, an increase of CHF 755. Expressed as percentages, they represent an increase of 0.77% in sales and an increase of 6.08% in operang prot. As we can see, the percentages give a beer context than just the actual sales or actual operang prots. If we extend this horizontal analysis to Nestlé’s Income Statement, we will see something like this below: 21 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng UCSC | Marna Marazzi Horizontal analysis does not provide you with answers as to why other income increases by 122.06% and other expenses decreases by 12.64%. We will need to carefully study the notes to the nancial statements and make an assessment if these 2016 amounts are likely to repeat in the years beyond. We would want to check if there are likely to be changes in the income from associates and joint ventures and also the reasons why the tax expenses vary so much from 2015 to 2016. As an investor, we would want to assess if these items are likely to have a further impact in future operaons. Horizontal analysis provides that rst step in seeing how the numbers move from one year to the next. Similarly, studying changes in Balance Sheet accounts can also enhance our understanding of the current and long-term nancial posion of the enty. From total assets perspecve, we can see that Nestlé has grown 6.38%, from CHF 123,992 to CHF 131,901, as a result of increases in both current assets and non-current assets. In parcular, cash has the biggest percentage increase of 63.60%. Short-term borrowings increased by 25.85%, accompanied by a decrease in long-term borrowings of 4.40%. Note that the largest decrease in quantum is retained earnings (CHF 5,144), but percentage wise, it has only dropped by 5.84%. This is why we will need to balance our review of horizontal analysis between the quantum and percentage since a large base may result in a smaller percentage change, and similarly, a small base may result in a very big percentage change. A word of cauon: we should not show a percentage change when the numbers swing from negave to posive or vice versa. In such cases, while we can mathemacally calculate the percentage dierence, they are not meaningful and not shown. For these instances, we should put the notaon “n.m.” to stand for not meaningful. Trend Analysis Trend percentages are a form of horizontal analysis. Trends indicate the direcon a business is taking. Trend percentages are computed by selecng a base year whose amounts are set equal to 100%. The amount for each following year is stated as a percentage of the base amount. To compute a trend percentage, divide an item for a later year by the base-year amount: Remember that income from operaons (or operang prot) is oen viewed as the primary measure of a company’s earnings quality. This is because operang income represents a company’s best predictor of the future net inows from its core business units. Net income from operaons is oen used in esmang the current value of the business. Nestlé’s operang prot for the last 5 years is as follows: 22 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng UCSC | Marna Marazzi We want to calculate a trend for the ve-year period 2012 through 2016. The rst year in the series (2012) is set as the base year. Trend percentages are computed by dividing each year’s amount by the 2012 amount. The resulng trend percentages follow (2012 = 100%): – Overall, Nestlé’s operang income has been lower than 2012 (the highest in the ve-year series). It dropped to a low of 81% in 2014 but has steadily climbed back to the same level as 2013. You can perform a trend analysis on any item you consider important. Trend analysis using Income Statement data is widely used for predicng the future. Horizontal and trend analyses highlight changes over me. It is a basic technique that will get you started in nancial statement analysis. Vercal Analysis Vercal analysis (or component analysis) shows the relaonship of nancial-statement items relave to a total, which is the 100% gure. All items on the parcular nancial statement are reported as a percentage of the base. • For the Income Statement, total revenue (sales) is usually the base • For the Balance Sheet, total assets is usually the base Prepare common-size nancial statements Common-Size Financial Statements – Report only percentages, no dollar amounts – Assists in comparison of dierent companies using a common denominator Benchmarking – It simply means comparing a company to some standard set by others (usually benchmarks are selected because they direct competors in the same industry or market, peers in the broader market, or just any other “aspiraon” enes) – Goal is improvement – Convert companies’ nancials to common size for easy and more meaningful comparisons Perform nancial rao analysis to make business decisions Financial raos are a major tool of nancial analysis: a rao expresses the relaonship of one number to another. The nancial raos are classied as follows: – Eciency raos 23 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng UCSC | Marna Marazzi – Financial strength raos – Protability raos – Investment raos Somemes you may nd dierent rao classicaons and even slightly dierent formulas for the raos we are about to discuss. Don’t be alarmed by any dierences; as long as you calculate the raos consistently, there is always value to nancial statement analysis. A weighing scale that is slightly inaccurate can sll tell you which item in a room is the heaviest or lightest. – Eciency Raos For companies that buy or make goods for sale, the ability to sell inventory and collect receivables is crical. In this secon, we discuss a number of raos that measure an enty’s ability to collect cash: • Inventory Turnover Companies generally strive to sell their inventory as quickly as possible: the faster inventory sells, the sooner cash comes in. → Inventory turnover measures the number of mes a company sells its average level of inventory during a year: a fast turnover indicates ease in selling inventory; a low turnover indicates diculty; however a too high a value can mean that the business is not keeping enough inventory on hand, which can lead to lost sales if the company can’t ll orders; therefore, a business strives for the most protable rate of turnover, not necessarily the highest rate → To compute inventory turnover, divide the cost of goods sold by the average inventory for the period (we use the cost of goods sold—not sales—in the computaon because both cost of goods sold and inventory are stated at cost) → Inventory turnover can also be expressed in number of days: this rao is called the inventory resident period (or days supply on hand, days inventory on hand, or something to that eect) • Accounts Receivable Turnover → Receivable turnover measures the ability to collect cash from customers: in general, the higher the rao, the beer (a low receivable turnover indicates ineecveness in collecng dues from customers; however, a receivable turnover that is too high may indicate that credit is too ght, and that may cause you to lose sales to good customers) → To compute accounts receivable turnover, divide net sales by average net accounts receivable: the rao tells how many mes during the year average receivables were turned into cash (note that we would normally exclude non-trading revenue and receivables) → We can also convert receivable turnover into days and refer to it as the receivable collecon period, also known as days sales outstanding, or days sales in receivables, or something similar or Convert average daily sales to DSO • Accounts Payable Turnover 24 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng UCSC | Marna Marazzi → Businesses buy their supplies and raw materials on credit, and take me to pay their accounts payable (a high account payable turnover rao means a business pays its suppliers very quickly, and a low payable turnover means a longer me period for payments to suppliers: generally, a lower payable turnover is beer than a higher one, as the business is making full use of the credit terms extended by its creditors; however, a business can’t stretch the payable period too far because no one would supply the business if it connued to be delinquent on its payments) → To compute payable turnover, divide cost of goods sold by the average accounts payable for the period. Again, we would only include trade-related payables and exclude items such as interest payable, short-term loan, tax payable, and so forth → We can also convert payables turnover into days and refer to it as the payable outstanding period (or days payable outstanding) • Cash Conversion Cycle → If we put the inventory resident period, receivable collecon period, and payable collecon period together, we can get a rough idea of how long it takes for a business to sell its inventory, collect payments, and make its payments to suppliers: this is what we call the cash conversion cycle → Shows overall liquidity (ideally, it has to be equal to 0 and if it has to be equal to 0, it means that the days that it takes to turn around the inventory, generate the sale, collect the sale and pay the suppliers are basically the same and so the company doesn’t need extra cash to fund these operang cycle – basically the suppliers are funding its operang cycle) → Computes total days it takes to convert inventory to receivables and back to cash, less the days to pay o suppliers • Asset Turnover Rao → Another way to examine eciency would be to assess the amount of resources used to generate sales or revenue (his can be done on a total assets basis, or somemes on a xed assets (i.e., PPE) basis) → This rao is calculated by dividing sales or revenue by average total assets • Rate of Return on Total Assets (ROA) → Measures how protably the company uses its assets – Financial Strength Raos Financial strength raos are indicators of an enty’s abilies to meet its nancial obligaons, either in the short-term or the long-term. Short-term indicators are usually called liquidity raos and long-term ones are usually called solvency raos. • Current Rao The most common rao evaluang current assets and current liabilies is the current rao, which is simply current assets divided by current liabilies. → The current rao measures the ability to pay current liabilies with current assets → In general, a higher current rao indicates a stronger nancial posion • Quick Rao (Acid-Test Rao) 25 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng UCSC | Marna Marazzi → It tells us whether a business could pass the “acid test” of paying all its current liabilies if they came due immediately → Uses narrower base to measure liquidity than the current rao does → Rate of .90 to 1.00 is acceptable in most industries • Debt Rao This relaonship between total liabilies and total assets is called the debt rao, which gives an indicaon of the degree of leverage or gearing of a company. → The debt rao tells us the proporon of assets nanced with debt → A debt rao of 1 reveals that debt has nanced all the assets → A debt rao of 0.50 means that debt nances half the assets → The higher the debt rao, the greater the pressure to pay interest and principal, the lower the rao, the lower the risk (it can be also expressed as a percentage) • Times-Interest-Earned Rao Analysts use another rao—the mes-interest-earned rao (or interest coverage rao)—to relate income to interest expense (it is supposed to count the number of mes a company covers its interests using its income) → To compute the mes-interest earned rao, divide income from operaons (operang income) by interest expense → It measures the number of mes operang income can cover interest expense and is also called the interest-coverage rao → A high rao indicates ease in paying interest; a low value suggests diculty – Protability raos The fundamental goal of a business is to earn a prot, and so the raos that measure protability are reported widely. Protability raos may be expressed in decimals or percentages. • Gross Prot, Operang Prot, and Net Prot Margin These raos show the percentage of each sales dollar earned as gross, operang, and net prot. If the company does not explicitly have a line on its Income Statement as operang prot (or prot from operaons), we can use earnings before interest and tax (EBIT) as a surrogate for operang prot. → Gross Prot Margin Percentage: it is the amount of prot enty makes from merely selling its products, before other operang costs are subtracted → Operang Prot Margin Percentage: it measures percentage of prot earned from sales in a company’s core business operaon • Return on Total Assets (ROA) → Measures a company’s success in using assets to earn a prot → The numerator is the net prot → The denominator is the average total assets, the sum of beginning and ending balances divided by 2 • Return on Equity (ROE) 26 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng UCSC | Marna Marazzi → This rao shows the relaonship between net income and ordinary shareholders’ investment in the company—how much income is earned for every $1 invested by the ordinary equity shareholders → Total return gure divided by the average total equity – Investment raos • Earnings per Ordinary Share (EPS) → Shows the amount of net income earned for each outstanding ordinary share → It is probably the most widely quoted of all nancial stascs and it is the only rao that appears at the boom of the Income Statement and the only nancial rao that has an accounng standard → It is computed by dividing net income available to ordinary shareholders by the weighted-average number of ordinary shares outstanding during the year • Price/Earnings Rao (P/E) → It shows how much an investor is willing to pay for each unit of earnings → It appears in every nancial secon of newspapers and online nancial databases • Dividend Yield → It measures percentage of a share’s market value returned annually to shareholders as dividends *Dividend yields may also be calculated for preference shares. • Book Value per Ordinary Share → Indicates recorded accounng amount for each share of ordinary shares → It is simply ordinary shareholders’ equity divided by the number of ordinary shares outstanding (ordinary equity equals total equity less preference equity) 27 Downloaded by Chiara Davoli ([email protected])
