Chapter 9 - Understanding Financial Statements.pdf

Understanding Financial Statements 9 CONTENT AREAS What are the Financial Statements? What is the Statement of Financial Position? What is the Statement of...

Understanding Financial Statements 9 CONTENT AREAS What are the Financial Statements? What is the Statement of Financial Position? What is the Statement of Comprehensive Income? What is the Statement of Changes in Equity? What is Financial Statement Analysis? Appendix A: XYZ Inc. Financial Statements LEARNING OBJECTIVES 1 | Describe the format and the items of the Statement of Financial Position and explain how the items are classified. 2 | Describe the structure of the Statement of Comprehensive Income. 3 | Describe the purpose of the Statement of Changes in Equity and describe its link with the Statement of Financial Position and Statement of Comprehensive Income. 4 | Describe the different types of liquidity ratios, risk analysis ratios, operating performance ratios and value ratios, and evaluate company performance using these ratios. 5 | Explain how to analyze a company’s financial statements using trend analysis and external comparisons. © CANADIAN SECURITIES INSTITUTE 9 2 INVESTMENT FUNDS IN CANADA KEY TERMS Key terms are defined in the Glossary and appear in bold text in the chapter. amortization long-term liabilities assets market ratios audit net profit margin auditor’s report operating performance ratios cash flow from operations/total debt ratio price-earnings ratio (p/e) current assets profit current liabilities quick ratio current ratio ratio analysis debt/equity ratio retained earnings depreciation return on common equity (ROE) ratio earnings per common share (EPS) risk analysis ratios equity statement of changes in equity financial statement analysis statement of comprehensive income fixed assets statement of financial position gross profit trend ratios gross profit margin ratio value ratios interest coverage ratio working capital inventory turnover ratio working capital ratio liabilities yield liquidity ratio © CANADIAN SECURITIES INSTITUTE  CHAPTER 9 | UNDERSTANDING FINANCIAL STATEMENTS 9 3 INTRODUCTION So far in this course, you have been introduced to the types of securities included in mutual funds and the methods used by portfolio managers to construct portfolios of securities. This chapter presents one type of fundamental analysis: the company analysis performed by mutual fund portfolio managers when selecting securities for inclusion in the mutual funds they manage. One of the jobs of a mutual fund portfolio manager is to assess the “true” value of the securities offered to the public by corporations. If that “true” value differs from the current market price, this is an indication of a buying or selling opportunity. To assess the value of a stock, fund managers need information about the companies they want to invest in, particularly information about earnings (or profits) these companies are likely to generate in the future. Earnings information is the cornerstone of choosing stocks because the price one is willing to pay today for a share of a company depends directly on estimates of how profitable the company will be in the future. If investors suddenly come to the conclusion that the future earnings of a company will be higher than was previously thought, that suggests the true value of the shares is higher than the price they may be trading for in the market today. Investors will likely buy these underpriced shares, bidding the price up until it reflects the new earnings forecast. In other words, the value of a share is primarily influenced by the company’s expected future earnings. Understanding the link between future earnings and share price is not that difficult, but trying to figure out what current information is relevant to determine what those future earnings might be can be a difficult task. Certainly, information about the company’s products, competition, the skill of its managers, and the training and dedication of its workers is all relevant, and better analyses result when a close examination of all relevant factors is made. However, the financial statements produced by management, and verified (or audited) by accounting firms, provide good summaries of how well the company has done in the recent past. While a complete treatment of financial statement analysis is far beyond the scope of this course, it will serve you well to be familiar with at least some basic concepts. Understanding some aspects of the security selection process will give you insight into the difficulty mutual fund portfolio managers have in always making good choices. WHAT ARE THE FINANCIAL STATEMENTS? Before we can discuss the tools of financial statement analysis, we start with the basics of financial statements. Throughout our discussion, we will refer to the set of financial statements of XYZ Corporation, a fictional company, included in Appendix A of this chapter. These financial statements are highly simplified in order to allow you to focus on a few key elements. Real financial statements are far more complex and are not presented here. Financial statements of publicly traded companies in Canada are produced according to International Financial Reporting Standards (IFRS). IFRS is a globally accepted high-quality accounting standard already used by public companies in over 100 countries around the world. IFRS is principle-based, with a focus on providing detailed disclosure. In principle-based accounting, guidelines are more general because the goal is to have the completed financial statements achieve a set of good reporting objectives. An example of a good reporting objective is sufficient disclosure of data so that an investor can make an objective analysis. IFRS requires an extensive and detailed disclosure by the company to explain why particular accounting treatments are utilized. © CANADIAN SECURITIES INSTITUTE 9 4 INVESTMENT FUNDS IN CANADA There are four essential financial statements produced by corporations: the Statement of Financial Position the Statement of Comprehensive Income the Statement of Changes in Equity the Statement of Cash flow While all four of these financial statements are important indicators of the performance of the company, we will look at only some of the key elements of the first three of these. WHAT IS THE STATEMENT OF FINANCIAL POSITION? The statement of financial position shows a company’s financial position at a specific date. In annual reports, that date is the last day of the company’s fiscal year. While many companies have a fiscal year end that corresponds with the calendar year end, i.e., December 31, this is not always the case. EXAMPLE Banks and trust companies traditionally end their fiscal year on October 31. In this instance, October 2022 would be the last month of the bank’s “fiscal 2022” while November 2022 would represent the first month of “fiscal 2023.” The statement of financial position shows what the company owns and what is owing to it. These items are called assets. This statement also shows the equity of the company which represents the shareholders’ interest in the company and what the company owes (called liabilities). Equity represents the excess of the company’s assets over its liabilities. Accordingly, the company’s total assets are equal to the sum of equity plus the company’s liabilities. A statement of financial position is prepared and presented in more or less the same way for all Canadian publicly traded companies. Assets, liabilities and shareholders’ equity are related by the following equation: Assets = Equity + Liabilities For XYZ Inc., total assets ($520,000) equal shareholders’ equity ($240,000) plus liabilities ($280,000). ASSETS Assets are classified as either current or fixed, with the dividing point usually being one year. Current assets are assets that are expected to be converted to cash within one year, although this conversion might be indirect. For example, consider trade receivables. Trade receivables represent the amounts owed to the company by clients who have bought goods but haven’t paid for them yet. For the vast majority of businesses, the average invoice is paid well within one year. Therefore, trade receivables are considered current assets because they will normally be paid and converted to cash within one year. While most companies will report many different kinds of current assets, there are only three current asset accounts for XYZ: cash, representing the total amount in all of the company’s deposit accounts; inventories, representing the finished and unfinished products which have not yet been sold; and trade receivables. © CANADIAN SECURITIES INSTITUTE  CHAPTER 9 | UNDERSTANDING FINANCIAL STATEMENTS 9 5 From the Statement of Financial Position, current assets for XYZ total $120,000. Current Assets Cash $20,000 Inventories 60,000 Trade Receivables 40,000 Total Current Assets $120,000 Fixed assets are those assets that are expected to last longer than one year. These are long-term assets used in the day-to-day operations of a company to produce the goods or services the company sells. They are not intended to be sold. Examples are automobiles, trucks, factories, computers and other office equipment. Since these assets last several accounting periods (years), it is only reasonable to adjust the values of those assets to reflect the fact that a certain amount is used up each period. With the exception of land, assets wear out over time or otherwise lose their usefulness. This used‑up amount is known as depreciation or amortization. On the XYZ Statement of Financial Position, fixed assets are shown as “net” plant and equipment. The term “net” means that depreciation has been removed from the original value of the fixed assets. Total fixed assets for XYZ is $400,000. Fixed Assets Net Plant and Equipment 400,000 Note that total assets for XYZ is the sum of current and fixed assets, or $520,000. LIABILITIES As with assets, liabilities are classified as either current or long‑term, with the same one‑year dividing line. There are three current liabilities for XYZ. The first, trade payables are the mirror image of the trade receivables seen on the asset section of the Statement of Financial Position. Trade payables represent the goods the company has bought for which payment has not yet been made. Notes payable represent loans that must be paid off by the company within one year. The last current liability account for XYZ is accrued charges. This account represents wages earned by employees but not yet paid, or taxes payable to the federal or provincial governments. From the Statement of Financial Position, current liabilities for XYZ total $80,000. Current Liabilities Trade Payables $20,000 Notes Payable 40,000 Accrued Charges 20,000 Total Current Liabilities $80,000 © CANADIAN SECURITIES INSTITUTE 9 6 INVESTMENT FUNDS IN CANADA Long‑term liabilities are liabilities not likely to be paid off within one year; such is the case for long‑term debt. This debt could be in the form of bonds issued by the corporation or a term loan made by a lender. The notes to the financial statements would be consulted to determine the precise composition of the debt. With long‑term liabilities of $200,000 added to the current liabilities, XYZ’s total liabilities are $280,000. SHAREHOLDERS’ EQUITY Shareholders’ equity refers to the amount contributed to the financing of the company by shareholders over time by one of two means. First, shareholders might have contributed by buying shares from the company when they were first issued in the primary market; that is the amount indicated in the common shares account. Second, all of the company’s annual profits that have not been distributed to shareholders (generally in the forms of dividends) but reinvested in the company continue to accumulate in shareholders’ equity over time: these are known as retained earnings. This decision to reinvest some of the profit comes from the company’s board of directors. From the Statement of Financial Position, total shareholders’ equity for XYZ is $240,000. Shareholders’ Equity Common Shares (100,000 outstanding shares) $40,000 Retained Earnings 200,000 Total Shareholders’ Equity $240,000 Therefore, the total of liabilities and shareholders’ equity is $520,000, exactly equal to the total asset figure indicated above. WHAT IS THE STATEMENT OF COMPREHENSIVE INCOME? Unlike the Statement of Financial Position, which shows what a company owns and owes at a single point in time, the statement of comprehensive income presents revenues and expenses over a specific period. In the case of XYZ, the period is one-year. Publicly traded companies provide shareholders with quarterly and annual financial statements. In that case, the Statement of Comprehensive Income will be over a three-month or a one-year period. All Statement of Comprehensive Incomes show the revenue generated for the period and then reduce that amount by charging off expenses of one kind or another. For XYZ, sales are reduced by the expenses that were incurred in order to generate the goods sold (Cost of Sales). These expenses include the cost of inventories used to produce the goods as well as the labour that went into their production. The revenue, net of the cost of sales (the cost of producing those goods), is known as gross profit. From the Statement of Comprehensive Income, the gross profit for XYZ is $400,000. Revenue $1,000,000 Less: Cost of Sales 600,000 Gross Profit $400,000 © CANADIAN SECURITIES INSTITUTE  CHAPTER 9 | UNDERSTANDING FINANCIAL STATEMENTS 9 7 Then, calculate all expenses. Expenses General and Administrative $200,000 Selling Expense 50,000 Depreciation 25,000 Interest Expense 20,000 Taxes 50,000 Total Expenses 345,000 From gross profit, subtract all expenses which leave profit. The profit for XYZ is $55,000. Gross Profit $400,000 Less: Total Expenses 345,000 Profit $55,000 WHAT IS THE STATEMENT OF CHANGES IN EQUITY? The profit or loss in a company’s most recent year is determined in the Statement of Comprehensive Income and then transferred to the statement of changes in equity. Retained earnings are profits earned over the years that have not been paid out to shareholders as dividends. These retained profits accrue to the shareholders, but the directors have decided for the present time to reinvest them in the business. The Statement of Changes in Equity is the link between the Statement of Comprehensive Income and the Statement of Financial Position as it makes the bridge between the yearly earnings that appear in the Statement of Comprehensive Income and the retained earnings that appear in the Statement of Financial Position. This statement starts with the opening balance (January 1, 20XX) of the retained earnings account. This is the same amount as the retained earnings from the December 31, previous year’s Statement of Financial Position. Since XYZ has earned $55,000 from this year’s activities after all goods, workers, managers, creditors and taxes have been paid, it only stands to reason that this additional amount belongs to the shareholders. Thus, retained earnings should increase by $55,000. Notice, however, that the board of directors paid a dividend on its common shares. Of the $55,000 earned, $30,000 has been paid out in cash in the form of common share dividends (100,000 shares outstanding × $0.30 per share). Retained Earnings at beginning of period $175,000 Plus: Profit for the period 55,000 Less: Dividends paid on common shares 30,000 Retained Earnings at end of period $200,000 © CANADIAN SECURITIES INSTITUTE 9 8 INVESTMENT FUNDS IN CANADA Therefore, retained earnings have grown by a total of $25,000. Since the year began with a retained earnings account balance of $175,000, the account balance at the end of this year should be $200,000 — and that is exactly what is shown on the Statement of Financial Position as at the end of the year. If the company experiences a loss instead of a profit, retained earnings are reduced by the amount of the loss. THE AUDITOR’S REPORT Canadian corporate law requires that every limited company appoint an auditor to represent shareholders and report to them annually on the company’s financial statements, expressing an opinion in writing as to their fairness. The only exception is for privately held corporations where all shareholders have agreed that an audit is not necessary. The auditor is appointed at the company’s annual meeting by a resolution of the shareholders and may be dismissed by them. In Canada the auditor’s report conventionally has four sections: The introductory section identifies the financial statements covered by the auditor’s report. The second section outlines the financial statement responsibilities of management. The third section outlines the auditor’s responsibilities and states how the audit was conducted. The purpose of the third section is for the auditor to inform the reader that the audit was planned and conducted in accordance with international auditing standards and that the auditor has made judgments in applying these standards. It explains to the reader the nature and extent of an audit. The fourth section gives the auditor’s opinion on the financial statements of the company being audited. This paragraph provides a statement on the fairness of the company’s financial statements presented in accordance with International Financial Reporting Standards. FINANCIAL STATEMENTS REVIEW How well do you understand the key purpose of the various financial statements? Complete the online learning activity to assess your knowledge. WHAT IS FINANCIAL STATEMENT ANALYSIS? Mutual fund managers rely extensively on the financial statements of companies they want to invest in. Their job is to find companies that will outperform their peers within an industry. In order to achieve this, fund managers must have an extensive knowledge of the industry, but they also must be able to analyze and interpret financial statements. Ratio analysis is one type of investment tool to perform this analysis. RATIO ANALYSIS The method most commonly used to evaluate financial statements is called ratio analysis, which shows the relationship between two quantities. For instance, a 2:1 ratio means that the first quantity is twice the amount of the second quantity. EXAMPLE A company with $100,000 in current assets and $50,000 in current liabilities is said to have a 2:1 ratio, or $2 of current assets for $1 of current liabilities. This ratio is the working capital ratio, which we discuss below. © CANADIAN SECURITIES INSTITUTE  CHAPTER 9 | UNDERSTANDING FINANCIAL STATEMENTS 9 9 In the context of financial analysis, ratios may be used to analyze a company’s liquidity, debt, return and stock value. The four main types of ratios commonly used in financial analysis are: Liquidity ratios are used to judge the company’s ability to meet its short-term commitments. An example is the working capital ratio, which shows the relationship between current assets and current liabilities. Risk analysis ratios show how well the company can deal with its debt obligations. For example, the debt/ equity ratio shows the relationship between the company’s borrowing and the capital invested in it by shareholders. Operating performance ratios illustrate how well management is making use of the company’s resources. The return on common equity, for example, correlates the company’s profit with the money shareholders have invested to produce it. These ratios include profitability and efficiency measures. Value ratios show the investor what the company’s shares are worth, or the return on owning them. An example is the price-earnings ratio, which links the market price of a common share to earnings per common share, and thus allows investors to rate the shares of companies within the same industry. Ratios must be used in context. One ratio alone does not tell an investor very much. Ratios are not proof of present or future profitability; they are only clues. An analyst who spots an unsatisfactory ratio may suspect unfavourable conditions. Conversely, analysts may conclude that a company is financially strong after compiling a series of ratios. The significance of any ratio is not the same for all companies. A ratio that compares company inventory does not have the same meaning for a company that builds planes, for example, as it does for a bakery shop. To be meaningful, company ratios must be compared with similar companies or within a similar industry. LIQUIDITY RATIOS Liquidity ratios help analysts to evaluate the ability of a company to turn current assets into cash to meet its short- term obligations. If a company is to remain solvent, it must be able to meet its current liabilities, and therefore it must have an adequate amount of working capital. WORKING CAPITAL RATIO OR CURRENT RATIO The ability of a company to meet its obligations, expand its volume of business, and take advantage of financial opportunities as they arise is, to a large extent, determined by its working capital or current ratio position. Frequent causes of business failure are the lack of sufficient working capital and the inability to liquidate current assets readily. Current Assets Current Ratio = Current Liabilities For XYZ: $120,000 Current Ratio = $80,000 XYZ’s current ratio is 1.5:1 which means there is $1.50 of current assets for each dollar of current liabilities. As discussed earlier, current assets are cash and other company possessions that can be readily turned into cash within one year. Current liabilities are liabilities of the company that must be paid within the year. The interpretation of this ratio depends on the type of business, the composition of current assets, inventory turnover rate and credit terms. A current ratio of 2:1 is generally considered good but not exceptional because it means the company has $2 cash and equivalents to pay for each $1 of its debt. However, the composition of current assets is also an important factor to assess the quality of the ratio. © CANADIAN SECURITIES INSTITUTE 9 10 INVESTMENT FUNDS IN CANADA EXAMPLE Company A reports current assets of 50% cash, 25% trade receivables, and 25% inventory. Company B reports 10% cash, 10% trade receivables, and 80% inventory. Both companies have a current ratio of 2:1, but which company is in a better position in terms of liquidity? Company A is in a better liquidity position than Company B. Company A could pay its current debts more easily and quickly. Also, if a current ratio of 2:1 is good, is a 20:1 current ratio ten times as good? No. If a company’s current ratio exceeds 5:1 and it consistently maintains such a high level, the company may have an unnecessary accumulation of funds that could indicate sales problems (too much inventory) or financial mismanagement. QUICK RATIO (THE ACID TEST) The second of the two most common corporate liquidity ratios, the quick ratio, is a more stringent test than the current ratio. In this calculation, inventories, which are generally not considered liquid assets, are subtracted from current assets. The quick ratio shows how well current liabilities are covered by cash and by items with a quick cash value. Current assets include inventories that, at times, may be difficult to convert into cash. As well, because of changing market conditions, inventories may be carried on the Statement of Financial Position at inflated values. Current Assets - Inventories Quick Ratio = Current Liabilities XYZ’s quick ratio is 0.75:1: $120,000 - $60,000 Quick Ratio = $80,000 The quick ratio offers a more conservative test of a company’s ability to meet its current obligations. For XYZ, the ratio is 0.75 to 1, which means there are $0.75 of current assets, exclusive of inventories, to meet each $1 of current liabilities. There is no absolute standard for this ratio, but if it is 1:1 or better, it suggests a good liquid position. However, companies with a quick ratio of less than 1:1 may be equally good if they have a high rate of inventory turnover because inventory that is turned over quickly is the equivalent of cash. FINANCIAL LEVERAGE (RISK ANALYSIS RATIOS) The capital structure of any company is made up of two elements: equity and debt. The analysis of a company’s capital structure enables analysts to judge how well the company can meet its financial obligations. Excessive borrowing increases the company’s costs because it must service its debt by paying interest on outstanding bank loans, notes payable, bonds or debentures. If a company cannot generate enough cash to pay the interest on its outstanding debt, then its creditors could force it into bankruptcy. If the company must sell off its assets to meet its obligations, then investors who have purchased bonds, debentures or stock in the company could lose some or all of their investment. Risk analysis ratios are mainly used to assess the weighting of debt in a company, the company’s ability to regularly pay interest due on its debt, and if the company will be able to fully reimburse debtholders in the event of bankruptcy. DEBT/EQUITY RATIO The debt/equity ratio pinpoints the relationship of debt to equity. If the ratio is too high, it may indicate that a company has borrowed excessively. Financial risk increases as the debt/equity ratio goes higher. If the debt burden is too large, it reduces the margin of safety protecting the debtholder’s capital, increases the company’s fixed © CANADIAN SECURITIES INSTITUTE  CHAPTER 9 | UNDERSTANDING FINANCIAL STATEMENTS 9 11 charges, reduces earnings available for dividends, and, in times of recession or high interest rates, could cause a financial crisis. Total Debt Outstanding (Short- + Long-Term Debt ) Debt/Equity Ratio = Equity XYZ’s debt/equity ratio is 1:1: $40,000 + $200,000 Debt/Equity Ratio = $240,000 You can interpret this result as $1.00 of debt for each dollar of equity. Creditors would normally not lend money to companies that show a debt/equity ratio that exceeds 0.50:1. XYZ seems to be largely financed by debt, which may indicate that debt is excessive. CASH FLOW FROM OPERATIONS/TOTAL DEBT RATIO The cash flow from operations/total debt ratio gauges a company’s ability to repay the funds it has borrowed. Bank advances are short-term and must normally be repaid or rolled over within a year. Corporate debt issues commonly have sinking funds requiring annual cash outlays. A company’s annual cash flow should therefore be adequate to meet these commitments. Before calculating this ratio, it is important to define cash flow from operations and consider its significance. Cash flow from operations = a company’s profit + all deductions not requiring a cash outlay (such as depreciation) – all additions not received in cash (such as share of profit of associates). Cash Flow From Operations Cash Flow From Operations/Total Debt Ratio = Total Debt Outstanding (Short- + Long-Term Debt) XYZ’s cash flow from operations/total debt ratio is 0.33:1 (net earnings + depreciation)/$240,000. $55,000 + $25,000 Cash Flow From Operations/Total Debt Ratio= $240,000 Cash flow from operations frequently provides a broader picture of a company’s earning power than profit alone. Why? Some accounts are considered expenses and are deducted from earnings to get to profit, but do not incur any cash outflows. For example, depreciation is an expense that reduces profit, but no actual cash amount has been paid out for that account. Consequently, cash flow from operations is considered by some analysts a better indicator of the ability to repay debts and other liabilities like dividends. It is particularly useful in comparing companies within the same industry. It can reveal whether a company, even one that shows little or no profit after depreciation, can meet its debts. A relatively high ratio of cash flow to debt is considered positive. Conversely, a low ratio is negative. Analysts use minimum standards to assess debt repayment capacity and provide another perspective on debt evaluation. Analysts usually calculate the cash flow from operations to total debt outstanding ratio for each of the last five fiscal years. An improving trend is desirable. A declining trend may indicate weakening financial strength, unless the individual ratios for each year are well above the minimum standards. INTEREST COVERAGE RATIO The interest coverage ratio reveals the ability of a company to pay the interest charges on its debt and indicates how well these charges are covered, based upon earnings available to pay them. Interest coverage indicates a margin of safety, since a company’s failure to meet its interest charges could result in bankruptcy. © CANADIAN SECURITIES INSTITUTE 9 12 INVESTMENT FUNDS IN CANADA All interest charges, including bank loans, and short-term and long-term debt must be taken into account to correctly assess interest coverage. Default on any one debt may impair the issuer’s ability to meet its obligations to the others, and lead to default on other debts. Interest coverage is generally considered to be the most important quantitative test of risk when considering a debt security. A level of earnings well in excess of interest requirements is deemed necessary as a form of protection for possible adverse conditions in future years. Overall, the greater the coverage, the greater the margin of safety. To assess the adequacy of the coverage, it is common to set criteria. For example, an analyst may decide that an industrial company’s annual interest requirements in each of the last five years should be covered at least three times by earnings available for interest payment in each year. At this level, the analyst would consider its debt securities to be of acceptable investment quality. A company may fail to meet these coverage standards without ever experiencing difficulties in fulfilling its debt obligations. However, the securities of such a company are considered a much higher risk because they lack an acceptable margin of safety. Thus, the interest coverage standards are only an indication of the likelihood that a company will be able to meet its interest obligations. It is also important to study the year-to-year trend in the interest coverage calculation. Ideally, a company should not only meet the industry standards for coverage in each of the last five or more years but increase its coverage. A stable trend, which means that the company is meeting the minimum standards, but not improving the ratio over the period, is also considered acceptable. However, a deteriorating trend suggests that further analysis is required to determine whether the company’s financial position has seriously weakened. The formula for interest coverage is: Earnings Before Interest and Taxes Interest Coverage Ratio = Total Interest Charges XYZ’s interest coverage ratio is 6.25 times. $55,000 + $50,000 + $20,000 XYZ's Interest Coverage Ratio = $20,000 The calculation shows that XYZ’s interest charges for the year were covered 6.25 times by profit available to pay them. Stated in another way, XYZ had $6.25 of profit out of which to pay every $1.00 of interest. OPERATING PERFORMANCE RATIOS The analysis of a company’s profitability and efficiency tells the investor how well management is making use of the company’s resources. In other words, these ratios analyze management performance. GROSS PROFIT MARGIN RATIO The gross profit margin ratio, as well as the net profit margin ratio, is useful both for calculating internal trend lines and for making comparisons with other companies, especially in industries such as food products and cosmetics, where turnover is high and competition is stiff. The gross margin is an indication of the efficiency of management in turning over the company’s goods at a profit. It shows the company’s rate of profit after allowing for the Cost of Sales. Revenue - Cost of Sales Gross Profit Margin Ratio = Revenue XYZ’s gross profit margin ratio is 40%. $1,000,000 - $600,000 XYZ Gross Profit Margin Ratio = $1,000,000 © CANADIAN SECURITIES INSTITUTE  CHAPTER 9 | UNDERSTANDING FINANCIAL STATEMENTS 9 13 NET PROFIT MARGIN Net profit margin is an important indicator of how efficiently the company is managed after taking both expenses and taxes into account. Because this ratio is the result of the company’s operations for the period, it effectively sums up management’s ability to run the business in a single figure. Profit Net Profit Margin = Revenue NET (OR AFTER-TAX) RETURN ON COMMON EQUITY (ROE) RATIO The return on common equity (ROE) represents the amount of profit returned as a percentage of shareholders’ equity. ROE measures a company’s profitability by revealing how much profit the company generates with the money shareholders have invested. The trend in the ROE indicates management’s effectiveness in maintaining or increasing profitability in relation to the company’s common equity capital. A declining trend suggests that operating efficiency is waning, although further quantitative analysis is needed to pinpoint the causes. For shareholders, a declining ratio shows that their investment is being employed less productively. This ratio is very important for common shareholders, since it reflects the profitability of their capital in the business. Profit Return on Common Equity Ratio = Equity XYZ’s return on common equity ratio is 22.9%. $55,000 XYZ Return on Common Equity Ratio = $240,000 INVENTORY TURNOVER RATIO The inventory turnover ratio measures the number of times a company’s inventory is turned over in a year. It may also be expressed as a number of days required to achieve turnover. A high turnover ratio is considered good. A company with a high turnover requires a smaller investment in inventory than one producing the same sales with a low turnover. Cost of Sales Inventory Turnover Ratio = Inventory XYZ’s inventory turnover ratio is 10 times. $600,000 XYZ Inventory Turnover Ratio = $60,000 Over the course of a 365-day year, XYZ turned over its inventory 365/10 or once every 36.5 days. To be meaningful, the inventory turnover ratio should be calculated using the cost of sales. If this information is not shown separately, the revenue figure may have to be used. This ratio indicates management’s efficiency in turning over the company’s inventory and can be used to compare one company with others in the same field. It also provides an indication of the adequacy of a company’s inventory for the volume of business being handled. If a company has an inventory turnover rate that is higher than its industry, it generally indicates a better balance between inventory and sales volume. The company is unlikely to be caught with too much inventory if the price of raw materials drops or the market demand for its products falls. There should also be less wastage because materials and products are not standing unused for long periods and deteriorating in quality and/or marketability. © CANADIAN SECURITIES INSTITUTE 9 14 INVESTMENT FUNDS IN CANADA On the other hand, if inventory turnover is too high in relation to industry norms, the company may have problems with shortages of inventory, resulting in lost sales. If a company has a low rate of inventory turnover, it may be because: the inventory contains an unusually large portion of unsaleable goods the company is holding excess inventory the value of the inventory has been overstated Since a large part of a company’s working capital is sometimes tied up in inventory, the way in which the inventory position is managed, directly affects earnings and the rate of return earned from the employment of the company’s capital in the business. VALUE RATIOS Ratios in this group – sometimes called market ratios – measure the way the stock market rates a company by comparing the market price of its shares to information in its financial statements. Price alone does not tell analysts much about a company unless there is a common way to relate the price to dividends and earnings. Value ratios do this. EARNINGS PER COMMON SHARE (EPS) RATIO In common stock analysis, great emphasis is placed on earnings per common share (EPS). This ratio shows the earnings available to each common share and is an important element in judging an appropriate market price for buying or selling common stock. A rising trend in EPS has favourable implications for the price of a stock. In practice, a common stock’s market price reflects the anticipated trend in EPS for the next 12 to 24 months, rather than the current EPS. Thus it is common practice to estimate EPS for the next year or two. Accurate estimates for longer periods are difficult because of the many variables involved. Profit Earnings per Common Share Ratio = Number of Common Shares Outstanding XYZ’s earnings per common share ratio is $0.55 $55,000 XYZ Earnings per Common Share Ratio = 100,000 Because of the importance of EPS, analysts pay close attention to possible dilution of the stock’s value caused by the conversion of outstanding convertible securities, the exercise of warrants, shares issued under employee stock options, and other changes. Fully diluted earnings per share can be calculated on common stock outstanding plus common stock equivalents such as convertible preferred stock, convertible debentures, stock options (under employee stock-option plans) and warrants. This figure shows the dilution in earnings per share that would occur if all equivalent securities were converted into common shares. Earnings from operations after all prior claims have been met belong to the common shareholders. The shareholders therefore will want to know how much has been earned on their shares. If profit is high, directors may declare and pay out a good portion as dividends. Even in growth companies, directors may decide to make at least a token payment because they realize that most shareholders like to feel some of the profits are flowing into their pockets. On the other hand, if profits are low or the company has suffered a loss, they may not pay dividends on the common shares. © CANADIAN SECURITIES INSTITUTE  CHAPTER 9 | UNDERSTANDING FINANCIAL STATEMENTS 9 15 DIVIDEND YIELD Common and preferred shares may pay dividends. The yield on common and preferred stocks is the annual dividend rate expressed as a percentage of the current market price of the stock. It represents the investor’s return on the investment. Annual dividend per share Dividend yield = Current market price PRICE-EARNINGS RATIO OR P/E MULTIPLE RATIO The price-earnings ratio or P/E ratio is probably the most widely employed of all financial ratios because it combines all the other ratios into one figure. P/E ratio compares the company’s current share price to its earnings per share. Current Price of Common Price Earnings Ratio = Earnings per Share Assuming that the current market price of XYZ common stock is $5 and that its earnings per common share is $0.55, the P/E ratio is $5/$0.55 or 9.1. The main reason for calculating earnings per common share – apart from indicating dividend protection – is to make a comparison with the share’s market price. The P/E ratio expresses this comparison in one convenient figure, showing that a share is selling at so many times its actual or anticipated annual earnings. At a price of $5, XYZ common shares are selling at 9.1 times the company’s earnings. P/E ratios enable the shares of one company to be compared with those of another. EXAMPLE Company A – Earnings per share: $2; Price: $20 Company B – Earnings per share: $1; Price: $10 $20 P/E ratio for Company A: = 10 $2 $10 P/E ratio for Company B: = 10 $1 Though earnings per share of Company A ($2) are twice those of Company B ($1), the shares of each company represent equivalent value because Company A’s shares, at $20 each, cost twice as much as Company B’s shares. In other words, both companies are selling at 10 times earnings. The elements that determine the quality of an issue – and therefore are represented in the P/E ratio – include: tangible factors contained in financial data, which can be expressed in ratios relating to liquidity, earnings trends, profitability, dividend payout, and financial strength (Statement of Financial Position ratios). intangible factors, such as quality of management, nature and prospects for the industry in which the issuing company operates, its competitive position, and its individual prospects. All these factors are taken into account when investors and speculators collectively decide what price a share is worth. © CANADIAN SECURITIES INSTITUTE 9 16 INVESTMENT FUNDS IN CANADA To compare the P/E ratio for one company’s common shares with that of other companies, the companies should usually be in the same industry. P/E ratios for various industries are available from different sources. In practice, however, most investment analysts and companies make their own projections of a company’s earnings for the next 12-month period and calculate P/E ratios on these projected figures in relation to the stock’s current market price. Because of the many variables involved in forecasting earnings, the use of estimates in calculations should be approached with great caution. The P/E ratio helps analysts to determine a reasonable value for a common stock at any time in a market cycle. By calculating a company’s P/E ratio over a number of years, the analyst will find considerable fluctuation, with high and low points. If the highs and lows of a particular stock’s P/E ratio remain constant over several stock market cycles, they indicate selling and buying points for the stock. A study of the P/E ratios of competitor companies and that of the relevant market subgroup index also helps to provide a perspective. The P/E ratio comparison assists in the selection process. EXAMPLE Two companies of equal stature in the same industry and both have similar prospects, but different P/E ratios. The company with the lower P/E ratio is usually the better buy. As a rule, P/E ratios increase in a rising stock market or with rising earnings. The reverse is true in a declining market or when earnings decline. Since the P/E ratio is an indicator of investor confidence, its highs and lows may vary from market cycle to market cycle. Much depends on changes in investor enthusiasm for a company or an industry over several years. Some investors consider the P/E ratio as a timing device for stock transactions, but it should not be relied on exclusively and should be used only in conjunction with other criteria. The P/E ratio approach to stock selection assumes that an investor should buy a stock if its P/E ratio is close to the low of its historical range and sell when it is near its highest point. Case Study | The Value of Advice: Using Market Ratios to Add Value for Investors (for information purposes only) Jerry is meeting with his client, Anne, to discuss investing new money into her existing non-registered investment portfolio. As a balanced growth investor with a long-term investment time horizon, Anne is hoping that Jerry can recommend a mutual fund that is focused on stable growth and, for tax planning purposes, one that produces minimal but tax-effective income. After reaffirming Anne’s goals and investment profile, Jerry recommends to Anne a blue-chip equity fund, one that uses a value investing approach. Jerry explains that using a value investing approach can help reduce taxable short-term capitals gains distributions, as the fund manager takes a long term, buy-and-hold approach to investing, reducing short-term investment turnover. Holding blue chip equities often means that these companies pay dividends, and the fund Jerry recommends to Anne does have a dividend yield of around 3%. However, with capital appreciation, few capital gains distributions, and dividend income eligible for tax credits, the fund meets Anne’s investment goals nicely. Anne, a knowledgeable investor, is interested in how a value style fund manager analyses companies to identify opportunities. Jerry explains that these fund managers will often use value or market ratios to look for stocks that, based on their analysis, the market is undervaluing relative to their industry peers. They often do this by: Determining the company’s earnings per share ratio and whether it is rising or falling: If a company’s earnings are consistently rising, then it is likely that it is well-managed and well positioned in its industry to continue to produce solid earnings growth. © CANADIAN SECURITIES INSTITUTE  CHAPTER 9 | UNDERSTANDING FINANCIAL STATEMENTS 9 17 Case Study | The Value of Advice: Using Market Ratios to Add Value for Investors (for information purposes only) Calculating the dividend yield to determine if the company’s stock is over- or underpriced: Yields that are too high can suggest that the current price of a stock is too low relative to what the company pays out to investors – this can indicate that investors are under valuing the stock’s price given the dividend cash flow per share. Examining the price/earnings (P/E) ratio to determine whether investors are over- or undervaluing the company’s stock: A high P/E ratio often indicates that investors are paying too much for a company’s future earnings relative to other companies’ stocks, while a low P/E ratio relative to its industry peers can suggest that a company is out of favour with investors — representing a possible opportunity for a fund manager to buy it cheaply and wait for other investors to realize the same thing. FINANCIAL RATIOS How well do you know the purpose of the different financial ratios? Complete the online learning activity to assess your knowledge. TREND ANALYSIS Ratios calculated from a company’s financial statements for only one year have limited value. They become meaningful when compared with other ratios either internally (with a series of similar ratios of the same company over a period) or externally (with comparable ratios of similar companies or with industry averages). Analysts identify trends by selecting a base date or period, treating the figure or ratio for that period as 100, and then dividing it into the comparable ratios for subsequent periods. Table 9.1 shows this calculation for a typical pulp and paper company: Table 9.1 | Pulp and Paper Company A – Earnings Per Share Year Year 1 Year 2 Year 3 Year 4 Year 5 EPS $1.18 $1.32 $1.73 $1.76 $1.99 1.18 1.32 1.73 1.76 1.99 1.18 1.18 1.18 1.18 1.18 Trend 100 112 147 149 169 The above example uses Year 1 as the base year. The earnings per share for that year, $1.18, is treated as equivalent to 100. The trend ratios for subsequent years are calculated by dividing 1.18 into the earnings per share ratio for each subsequent year. © CANADIAN SECURITIES INSTITUTE 9 18 INVESTMENT FUNDS IN CANADA A similar trend line over the same period for Pulp and Paper Company B is shown in Table 9.2. Table 9.2 | Pulp and Paper Company B – Earnings Per Share Year Year 1 Year 2 Year 3 Year 4 Year 5 EPS $0.71 $0.80 $0.90 $0.84 $0.78.71.80.90.84.78.71.71.71.71.71 Trend 100 113 127 118 110 Trend ratio calculations are useful because they clearly show changes. Company A shows a steady earnings per share growth during the period, while Company B shows a decline in earnings for the recent years. While it is not always the case, these trends can help analysts to forecast future earnings. EXTERNAL COMPARISONS Ratios are most useful when comparing financial results of companies in the same or similar industries (such as comparing a distiller with a brewer). Differences shown by the trend lines not only help to put the earnings per share of each company in historical perspective, but also show how each company has fared in relation to others. Different industries may have different industry standards for the same ratio. In fact, a range is often employed rather than a specific target number. In external comparisons, not only should the companies be similar in operation, but also the basis used to calculate each ratio compared should be the same. For example, there is no point comparing the inventory turnover ratios of two companies if one calculation uses “Cost of Sales” and the other uses “Revenue.” This comparison would be inaccurate since the basis of calculation is different. Determining which items on a financial statement should be included in a ratio can be difficult. An investor may not be able to make a valid comparison between comparing ABC Ltd. and DEF Ltd. if the research on each came from two different analysts. Different assumptions can result in one analyst including an item while an equally competent analyst may choose not to include it. For example, one analyst may include a bond maturing in five years as short-term debt while another analyst may consider that same security to be a long-term debt. Because there is flexibility in calculating the ratios, two analysts could have differing opinions on the quality of an investment, depending on the assumptions that each made. In addition to comparisons between companies in the same industry, industry ratios can be used to compare the performance of individual companies. Industry ratios represent the average for that particular ratio of all the companies analyzed in that specific industry. Evaluating a company should be made within the content of overall industry performance. For example, a company being analyzed may have a ratio that gives it a relative standing above all others in the industry, but due to a recession, all companies within the industry may be below historical industry operating norms. To be thorough, an analyst must compare the company to both the current average of the industry, as well as the historical industry standard. © CANADIAN SECURITIES INSTITUTE  CHAPTER 9 | UNDERSTANDING FINANCIAL STATEMENTS 9 19 SUMMARY After reading this chapter, you should be able to: 1. Describe the format and the items of the Statement of Financial Position and explain how the items are classified. One section of the Statement of Financial Position shows what the company owns and what is owing to it. These items are called assets. Assets are classified as current or fixed assets. The other sections of the Statement of Financial Position show: 1. what the company owes (current and long-term liabilities) and 2. the shareholders’ equity or net worth of the company which represents the shareholders’ interest in the company. 2. Describe the structure of the Statement of Comprehensive Income. The Statement of Comprehensive Income presents revenues and expenses over a specific period. Earnings (or profits) are calculated as sales minus all expenses, interests and taxes. 3. Describe the purpose of the Statement of Changes in Equity and describe its link with the Statement of Financial Position and Statement of Comprehensive Income. The Statement of Changes in Equity represents the sum of all retained earnings since the inception of the company. The Statement of Changes in Equity is the link between the Statement of Comprehensive Income and the Statement of Financial Position as it makes the bridge between the earnings that appear in the Statement of Comprehensive Income and the retained earnings that appear in the Statement of Financial Position. Opening balance is the closing balance of the previous year’s retained earnings. Profits are added and dividends are deducted to arrive at the closing balance of retained earnings. This closing balance is then transferred to the Statement of Financial Position as retained earnings. 4. Describe the different types of liquidity ratios, risk analysis ratios, operating performance ratios and value ratios, and evaluate company performance using these ratios. Liquidity ratios are used to evaluate a company’s ability to turn assets into cash to meet its short-term commitments. Ratios in this category look at the relationship between assets and liabilities, specifically, how well current liabilities are covered by the cash flow generated by the company’s operating activities. Risk analysis ratios show how well a company can meet its debt obligations. Because financial risk can increase with higher levels of debt, these ratios help to show whether a company has sufficient earnings to repay the funds it has borrowed and its ability to make regular interest payments on its outstanding debt. Operating performance ratios illustrate how well management is making use of company resources. These ratios focus on measuring the profitability and efficiency of operations. They look specifically at the company’s ability to manage its resources by taking into account sales and the costs and expenses incurred in producing earnings. Value ratios show the investor what the company’s shares are worth, or the return on owning them, by comparing the market price of the shares to information in the company’s financial statements. For example, these ratios look at the earnings available to common shareholders, the dividend yield or return on company shares, and the ultimate valuation of a company through the price-earnings ratio. © CANADIAN SECURITIES INSTITUTE 9 20 INVESTMENT FUNDS IN CANADA 5. Explain how to analyze a company’s financial statements using trend analysis and external comparisons. Financial ratios become meaningful when compared with other ratios over a period. A series of similar ratios for the same company can be compared; or the company’s ratios can be compared to those of similar companies or industry averages. Ratios are most useful when comparing financial results of companies in the same or similar industries. Trend lines help to put the ratios of each company in historical perspective and identify how each company has fared in relation to others. REVIEW QUESTIONS Now that you have completed this chapter, you should be ready to answer the Chapter 9 Review Questions. FREQUENTLY ASKED QUESTIONS If you have any questions about this chapter, you may find answers in the online Chapter 9 FAQs. © CANADIAN SECURITIES INSTITUTE  CHAPTER 9 | UNDERSTANDING FINANCIAL STATEMENTS 9 21 APPENDIX A: XYZ INC. FINANCIAL STATEMENTS ASSETS Current Assets Cash $20,000 Inventories 60,000 Trade Receivables 40,000 Total Current Assets 120,000 Fixed Assets Net Plant and Equipment 400,000 Total Assets $520,000 LIABILITIES Current Liabilities Trade payables $20,000 Notes Payable 40,000 Accrued Charges 20,000 Total Current Liabilities 80,000 Long-term Liabilities Long-term Debt 200,000 Total Liabilities $280,000 Shareholders’ Equity Common Shares (100,000 outstanding shares) $40,000 Retained Earnings 200,000 Total Shareholder’s Equity 240,000 Total Liabilities and Shareholders’ Equity $520,000 © CANADIAN SECURITIES INSTITUTE 9 22 INVESTMENT FUNDS IN CANADA XYZ Inc. Statement of Comprehensive Income for the Year Ending December 31, 20XX Sales $1,000,000 Cost of Sales (600,000) Gross profit 400,000 Expenses General and Administrative ($200,000) Selling Expense (50,000) Depreciation (25,000) Interest Expense (20,000) Taxes (50,000) Total Expenses (345,000) Profit $55,000 Earnings Per Common Share $0.55 Statement of Changes in Equity as at December 31, 20XX Retained Earnings at beginning of period $175,000 Plus: Profit for the period 55,000 Less: Dividends paid on common shares (30,000) Retained Earnings at end of period $200,000 © CANADIAN SECURITIES INSTITUTE