Financial Statements and Analysis PDF

Principles of Managerial Finance Arab World Edition Gitman, Zutter, Elali, Al Roubaie Chapter 2: Financial Statements and Analysis Lecturer: Dr. Ali Hamad Fetais © Pearson E...

Principles of Managerial Finance Arab World Edition Gitman, Zutter, Elali, Al Roubaie Chapter 2: Financial Statements and Analysis Lecturer: Dr. Ali Hamad Fetais © Pearson Education 2013 2-0  Learning Goals LG1: Understand who uses financial ratios, and how. LG2: Use ratios to analyze a firm’s liquidity and activity. LG3: Discuss the relationship between debt and financial leverage and the ratios used to analyze a firm’s debt. LG4: Use ratios to analyze a firm’s profitability and market value. LG5: Use a summary of financial ratios to perform a complete ratio analysis. © Pearson Education 2013 2-1  Using Financial Ratios: Interested Parties Ratio analysis involves methods of calculating and interpreting financial ratios to assess a firm’s financial condition and performance. It is of interest to shareholders, creditors, and the firm’s own management.  Current and prospective shareholders are interested in the firm’s current and future level of risk and return, which directly affect share price.  Creditors are interested in the short-term liquidity of the company and its ability to make interest and principal payments.  Management is concerned with all aspects of the firm’s financial situation, and it attempts to produce financial ratios that will be considered favorable by both owners and creditors. © Pearson Education 2013 2-2  Using Financial Ratios: Types of Ratio Comparisons Cross-sectional analysis - the comparison of different firms’ financial ratios at the same point in time. Time-series analysis - the evaluation of the firm’s financial performance over time. © Pearson Education 2013 2-3  Using Financial Ratios: Types of Ratio Comparisons Cross-sectional analysis is the comparison of different firms’ financial ratios at the same point in time; involves comparing the firm’s ratios to those of other firms in its industry or to industry averages. Benchmarking is a type of cross-sectional analysis in which the firm’s ratio values are compared to those of a key competitor or group of competitors that it wishes to emulate. Industry comparative analysis is another type of cross sectional analysis. Used to compare one firm’s financial performance to the industry’s average performance. © Pearson Education 2013 2-4  Using Financial Ratios: Types of Ratio Comparisons Time-series analysis is the evaluation of the firm’s financial performance over time using financial ratio analysis. Comparison of current to past performance, using ratios, enables analysts to assess the firm’s progress. Developing trends can be seen by using multiyear comparisons. The most informative approach to ratio analysis combines cross-sectional and time-series analyses. © Pearson Education 2013 2-5  Using Financial Ratios: Types of Ratio Comparisons Combined Analysis - simply uses a combination of both time series analysis and cross-sectional analysis. © Pearson Education 2013 2-6  Using Financial Ratios: Types of Ratio Comparisons Figure 2.1 Combined Analysis © Pearson Education 2013 2-7  Using Financial Ratios: Cautions for Doing Ratio Analysis 1. Ratios that reveal large deviations from the norm merely indicate the possibility of a problem. 2. A single ratio does not generally provide sufficient information from which to judge the overall performance of the firm. 3. The ratios being compared should be calculated using financial statements dated at the same point in time during the year. 4. It is preferable to use audited financial statements. 5. The financial data being compared should have been developed in the same way. 6. Results can be distorted by inflation. © Pearson Education 2013 2-8  Ratio Analysis Example We will illustrate the use of financial ratios for analyzing financial statements using the Awal Company Income Statements and Balance Sheets presented earlier in Tables 2.1 and 2.2. © Pearson Education 2013 2-9  The Balance Sheet Table 2.2 (top) Awal Company Balance Sheets (US$000) © Pearson Education 2013 2-10  The Balance Sheet Table 2.2 (bottom) Awal Company Balance Sheets (US$000) © Pearson Education 2013 2-11  The Income Statement Table 2.1 Awal Company Income Statements (US$000) © Pearson Education 2013  Liquidity Ratios: Current Ratio The current ratio is a measure of the firm’s ability to meet its short-term obligations. It is calculated as: Current ratio = total current assets total current liabilities The current ratio for Awal Company in 2012 is: Current ratio = US$1,233,000 = 1.97 US$620,000 © Pearson Education 2013 2-13  Liquidity Ratios: Quick (Acid-Test) Ratio The quick (acid-test) ratio is similar to the current ratio except that it excludes inventory. It is calculated as: Quick ratio = total current assets - inventory total current liabilities The quick ratio for Awal Company in 2012 is: Quick ratio = US$1,233,000 - US$289,000 = 1.51 US$620,000 © Pearson Education 2013 2-14  Activity Ratios: Inventory Turnover Inventory turnover commonly measures the activity, or liquidity, of a firm’s inventory. It is calculated as: Inventory turnover = Cost of Goods Sold Inventory Applying this relationship to Awal Company in 2012 gives: Inventory turnover = US$2,088,000 = 7.2 US$289,000 © Pearson Education 2013 2-15  Activity Ratios: Inventory Turnover Inventory turnover can be easily converted into an average age of inventory by dividing it into 365. Average age of inventory = 365 Inventory Turnover For Awal Company, the average age of inventory in 2012 is: Average age of inventory = 365 = 50.7 days 7.2 © Pearson Education 2013 2-16  Activity Ratios: Average Collection Period The average collection period, or average age of accounts receivable, is useful in evaluating credit and collection policies. ACP = Accounts Receivable Annual Sales/365 The average collection period for Awal Company in 2012 is: ACP = US$503,000 = 59.7 days US$3,074,000/365 © Pearson Education 2013 2-17  Activity Ratios: Average Payment Period The average payment period is the average amount of time needed to pay accounts payable. APP = Accounts Payable Annual Purchases/365 Assuming Awal Company’s purchases equaled 70 percent of its cost of goods sold in 2012, its average payment period is: APP = US$382,000 = 95.4 days (.70 x US$2,088,000)/365 © Pearson Education 2013 2-18  Activity Ratios: Total Asset Turnover The total asset turnover indicates the efficiency with which the firm uses its assets to generate sales. It is calculated as: Total Asset Turnover = Net Sales Total Assets The value of Awal Company’s total asset turnover in 2012 is: Total Asset Turnover = US$3,074,000 =.85 US$3,597,000 © Pearson Education 2013 2-19  Debt Ratios: Debt Ratio The debt ratio measures the proportion of total assets financed by the firm’s creditors. The higher this ratio, the greater the amount of other people’s money being used to generate profits. Debt ratio = Total liabilities/Total assets The debt ratio for Awal Company in 2012 is: Debt ratio = US$1,643,000 / US$3,597,000 = 45.7% © Pearson Education 2013 2-20  Debt Ratios: Times Interest Earned Ratio The times interest earned ratio, sometimes called the interest coverage ratio, measures the firm’s ability to make contractual interest payments. The higher its value, the better able the firm is to fulfil its interest obligations. Times Interest Earned = EBIT/Interest The times interest earned ratio for Awal Company in 2012 is: Times Interest Earned = US$418,000 / US$93,000 = 4.5 © Pearson Education 2013 2-21  Profitability Ratios: Gross Profit Margin The gross profit margin measures the percentage of each sales amount remaining after the firm has paid for its goods. The higher the gross profit margin, the better. GPM = Gross Profit/Net Sales Awal Company’s gross profit margin for 2012 is: GPM = US$986,000 / US$3,074,000 = 32.1% © Pearson Education 2013 2-22  Profitability Ratios: Operating Profit Margin The operating profit margin measures the percentage of each sales amount remaining after all costs and expenses apart from interest, taxes, and preferred stock dividends are deducted. It represents ‘pure profits’ earned on each sales amount. OPM = Operating Profits/Net Sales Awal Company’s operating profit margin for 2012 is: OPM = US$418,000 / US$3,074,000 = 13.6% © Pearson Education 2013 2-23  Profitability Ratios: Net Profit Margin The net profit margin measures the percentage of each sales amount remaining after all costs and expenses, including interest, taxes, and preferred stock dividends, have been deducted. The higher the firm’s net profit margin, the better. NPM = Earnings Available to Common Stockholders Sales Awal Company’s net profit margin for 2012 is: NPM = US$221,000 / US$3,074,000 = 7.2% © Pearson Education 2013 2-24  Profitability Ratios: Earning Per Share (EPS) The firm’s earnings per share (EPS) represent the cash earned during the period on behalf of each outstanding share of common stock. EPS = Earnings Available to Common Stockholders Number of Shares Outstanding Awal Company’s earnings per share in 2012 are: EPS = US$221,000 / US$76,262 = US$2.90 © Pearson Education 2013 2-25  Profitability Ratios: Return on Total Assets (ROA) The return on total assets (ROA), often called the return on investment (ROI), measures the overall effectiveness of management in generating profits with its available assets. ROA = Earnings Available to Common Stockholders Total Assets Awal Company’s return on total assets in 2012 is: ROA = US$221,000 / US$3,597,000 = 6.1% © Pearson Education 2013 2-26  A Complete Ratio Analysis: DuPont System of Analysis 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. ROA = Net profit margin × Total asset turnover Substituting the appropriate formulas into the equation and simplifying results in the formula given earlier, © Pearson Education 2013 2-27  Profitability Ratios: Return on Common Equity (ROE) The return on common equity (ROE) measures the return earned on the common stockholders’ investment in the firm. ROE = Earnings Available to Common Stockholders Common Stock Equity This ratio for Awal Company in 2012 is: ROE = US$221,000 / US$1,754,000 = 12.6% © Pearson Education 2013 2-28  Market Ratios: Price/Earnings (P/E) Ratio The price/earnings (P/E) ratio measures the amount that investors are willing to pay for each dollar of a firm’s earnings. The higher the P/E ratio, the greater is investor confidence. P/E = Market Price Per Share of Common Stock Earnings Per Share If Awal Company’s common stock at the end of 2012 was selling at US$32.25, using the EPS of US$2.90, the P/E ratio at year-end 2012 is: P/E = US$32.25 / US$2.90 = 11.1 © Pearson Education 2013 2-29  Market Ratios: Market/Book (M/B) Ratio The market/book (M/B) ratio provides an assessment of how investors view the firm’s performance. It relates the market value of the firm’s shares to their book—strict accounting— value. We first find the book value per share of common stock: BV/Share = Common Stock Equity Number of Shares of Common Stock Substituting the appropriate values for Awal Company from its 2012 balance sheet, we get: BV/Share = US$1,754,000 / 76,262 = US$23.00 © Pearson Education 2013 2-30  Market Ratios: Market/Book (M/B) Ratio The formula for the market/book ratio is: M/B Ratio = Market Price per Share of Common Stock Book Value per Share of Common Stock Substituting Awal Company’s end of 2012 common stock price of US$32.25 and its US$23.00 book value per share, we get: M/B Ratio = US$32.25 / US$23.00 = 1.40 © Pearson Education 2013 2-31  A Complete Ratio Analysis: Summarizing All Ratios – Table 2.7 © Pearson Education 2013 2-32  A Complete Ratio Analysis: Summarizing All Ratios – Table 2.7 cont’d © Pearson Education 2013 2-33