Analysis and Interpretation of Financial Statements 2 PDF

Analysis and Interpretation of Financial Statements 2 Mr. Ian A. obrero Financial Statement (FS) Analysis is the process of evaluating risks, performance, financial health, and future prospects of a business by subjecting financial statement data to computational and analytical tec...

Analysis and Interpretation of Financial Statements 2 Mr. Ian A. obrero Financial Statement (FS) Analysis is the process of evaluating risks, performance, financial health, and future prospects of a business by subjecting financial statement data to computational and analytical techniques with the objective of making economic decisions(White et.al 1998). Three kinds of FS analysis techniques Horizontal analysis Vertical analysis Financial ratios This lesson will focus on ratio analysis Ratio analysis Expresses the relationship among selected items of financial statement data. The relationship is expressed in terms of a percentage, a rate, or a simple proportion. A financial ratio is composed of a numerator and a denominator. There are many ratios used in business. These ratios are generally grouped into three categories: (a) profitability, (b) efficiency, and (c) financial health. Profitability ratios measure the ability of the company to generate income from the use of its assets and invested capital as well as control its cost. The following are the commonly used profitability ratios: 1. Gross profit ratio 2. Operating income ratio 3. Net profit ratio 4. Return on asset(ROA) 5. Return on equity(ROE Gross profit ratio reports the peso value of the gross profit earned for every peso of sales. We can infer the average pricing policy from the gross profit margin. Formula: Gross Profit Margin = Gross Profit Net Sales Operating income ratio expresses operating income as a percentage of sales. It measures the percentage of profit earned from each peso of sales in the company’s core business operations. A company with a high operating income ratio may imply a lean operation and have low operating expenses. Maximizing operating income depends on keeping operating costs as low as possible. Formula: Operating Income Margin = Operating Income Net Sales Net profit ratio relates the peso value of the net income earned to every peso of sales. This shows how much profit will go to the owner for every peso of sales made. Formula: Net profit margin = Net Income Net Sales Return on asset(ROA) measures the peso value of income generated by employing the company’s assets. It is viewed as an interest rate or a form of yield on asset investment. Formula: Return on assets= Net Income Average Assets There are two acceptable denominators for ROA – ending balance of total assets or average of total assets. Average assets is computed as beginning balance + ending balance divided by 2. Return on equity(ROE measures the return (net income) generated by the owner’s capital invested in the business. Similar to ROA, the denominator of ROE may also be total equity or average equity. Formula: Return on equity= Net Income Average Equity Quiz 1: Prepare the Profitability Ratios of the FS below Operational Efficiency Ratio measures the ability of the company to utilize its assets. Operational efficiency is measured based on the company’s ability to generate sales from the utilization of its assets, as a whole or individually. The turnover ratios are primarily used to measure operational efficiency. Turn Over Ratios Asset turnover - measures the peso value of sales generated for every peso of the company’s assets. The higher the turnover rate, the more efficient the company is in using its assets. Fixed asset turnover - is indicator of the efficiency of fixed assets in generating sales. Inventory turnover - is measured based on cost of goods sold and not sales. As such both the numerator and denominator of this ratio are measured at cost. It is an indicator of how fast the company can sell inventory. Accounts receivables turnover - the measures the number of times the company was able to collect on its average accounts receivable during the year. An alternative to accounts receivable turnover is “days in accounts receivable”. This measures the company’s collection period which is the number of days from sale to collection. Example: Financial Health Ratios look into the company’s solvency and liquidity ratios. Solvency refers to the company’s capacity to pay their long term liabilities. Liquidity ratio intends to measure the company’s ability to pay debts that are coming due (short term debt). Solvency Ratios Debt ratio - indicates the percentage of the company’s assets that are financed by debt. A high debt to asset ratio implies a high level of debt. Equity ratio indicates the percentage of the company’s assets that are financed by capital. A high equity to asset ratio implies a high level of capital. Debt to equity ratio - indicates the company’s reliance to debt or liability as a source of financing relative to equity. A high ratio suggests a high level of debt that may result in high interest expense. Interest coverage ratio - measures the company’s ability to cover the interest expense on its liability with its operating income. Creditors prefer a high coverage ratio to give them protection that interest due to them can be paid. Liquidity Ratios Current ratio is used to evaluate the company’s liquidity. It seeks to measure whether there are sufficient current assets to pay for current liabilities. Creditors normally prefer a current ratio of 2. Quick ratio is a stricter measure of liquidity. It does not consider all the current assets, only those that are easier to liquidate such as cash and accounts receivable that are referred to as quick assets. (Also called Acid-test Ratio) Example Quiz 2: Prepare the Profitability, Operational Efficiency, and Financial Health Ratios