Financial Statement Analysis PDF

lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng UCSC | Marna Marazzi Preparaon of Cash Flow Statement - direct method We have already seen the preparaon of the Cash Flow Statement according to the direct method, but there is another way to work with the direct method an...

lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng UCSC | Marna Marazzi Preparaon of Cash Flow Statement - direct method We have already seen the preparaon 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 dierence because, suppose that we don’t have the imput of the cash account, could we sll be able, with one Income Statement and two Balance Sheets, to work out the direct cash collecon from customers, payments to suppliers and payments of addional 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 operaons are comprised of four items: Cash receipts from customers Sales of current period + beginning period Accounts Receivable Cash potenally collecble during the year - end of period Accounts Receivable Cash receipts from customers Cash disbursements to suppliers Purchases + beginning period Accounts Payable Cash potenally payable during the year - end of period Accounts Payable Cash disbursements to suppliers Cash disbursements on operang expenses General expenses - beginning period Prepaid-Expenses + beginning period Expenses Payable Cash potenally payable during the year + ending Prepaid Expenses - ending Expenses Payable Cash disbursements on operang expenses Cash disbursements to tax authority Property Taxes + beginning period Property Taxes Payable Cash potenally 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 Accounng UCSC | Marna Marazzi FINANCIAL STATEMENT ANALYSIS Perform basic (horizontal and vercal) analysis of nancial statements – Horizontal Analysis The study of percentage changes from year to year is called horizontal analysis. Compung 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 Illustraon: Nestlé Nestlé’s sales increased by 0.77% during 2016, and operang prot 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 operang prot for the year 2016 and 2015 (CHF 89,469 compared to CHF 88,785, and CHF 13,163 compared to CHF 12,408, respecvely). For sales, the amount change is an increase of CHF 684, and for operang prot, an increase of CHF 755. Expressed as percentages, they represent an increase of 0.77% in sales and an increase of 6.08% in operang prot. As we can see, the percentages give a beer context than just the actual sales or actual operang prots. 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 Accounng UCSC | Marna 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 operaons. 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 posion of the enty. From total assets perspecve, 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 parcular, 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 cauon: we should not show a percentage change when the numbers swing from negave to posive or vice versa. In such cases, while we can mathemacally calculate the percentage dierence, they are not meaningful and not shown. For these instances, we should put the notaon “n.m.” to stand for not meaningful. Trend Analysis Trend percentages are a form of horizontal analysis. Trends indicate the direcon a business is taking. Trend percentages are computed by selecng 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 operaons (or operang prot) is oen viewed as the primary measure of a company’s earnings quality. This is because operang income represents a company’s best predictor of the future net inows from its core business units. Net income from operaons is oen used in esmang the current value of the business. Nestlé’s operang prot for the last 5 years is as follows: 22 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng UCSC | Marna 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 resulng trend percentages follow (2012 = 100%): – Overall, Nestlé’s operang 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 predicng the future. Horizontal and trend analyses highlight changes over me. It is a basic technique that will get you started in nancial statement analysis. Vercal Analysis Vercal analysis (or component analysis) shows the relaonship of nancial-statement items relave to a total, which is the 100% gure. All items on the parcular 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 dierent 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 competors in the same industry or market, peers in the broader market, or just any other “aspiraon” enes) – Goal is improvement – Convert companies’ nancials to common size for easy and more meaningful comparisons Perform nancial rao analysis to make business decisions Financial raos are a major tool of nancial analysis: a rao expresses the relaonship of one number to another. The nancial raos are classied as follows: – Eciency raos 23 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng UCSC | Marna Marazzi – Financial strength raos – Protability raos – Investment raos Somemes you may nd dierent rao classicaons and even slightly dierent formulas for the raos we are about to discuss. Don’t be alarmed by any dierences; as long as you calculate the raos consistently, there is always value to nancial statement analysis. A weighing scale that is slightly inaccurate can sll tell you which item in a room is the heaviest or lightest. – Eciency Raos For companies that buy or make goods for sale, the ability to sell inventory and collect receivables is crical. In this secon, we discuss a number of raos that measure an enty’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 diculty; 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 protable 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 computaon because both cost of goods sold and inventory are stated at cost) → Inventory turnover can also be expressed in number of days: this rao is called the inventory resident period (or days supply on hand, days inventory on hand, or something to that eect) • Accounts Receivable Turnover → Receivable turnover measures the ability to collect cash from customers: in general, the higher the rao, the beer (a low receivable turnover indicates ineecveness in collecng 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 rao 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 collecon 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 Accounng UCSC | Marna Marazzi → Businesses buy their supplies and raw materials on credit, and take me to pay their accounts payable (a high account payable turnover rao 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 beer 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 connued 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 collecon period, and payable collecon 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 operang cycle – basically the suppliers are funding its operang cycle) → Computes total days it takes to convert inventory to receivables and back to cash, less the days to pay o suppliers • Asset Turnover Rao → Another way to examine eciency would be to assess the amount of resources used to generate sales or revenue (his can be done on a total assets basis, or somemes on a xed assets (i.e., PPE) basis) → This rao is calculated by dividing sales or revenue by average total assets • Rate of Return on Total Assets (ROA) → Measures how protably the company uses its assets – Financial Strength Raos Financial strength raos are indicators of an enty’s abilies to meet its nancial obligaons, either in the short-term or the long-term. Short-term indicators are usually called liquidity raos and long-term ones are usually called solvency raos. • Current Rao The most common rao evaluang current assets and current liabilies is the current rao, which is simply current assets divided by current liabilies. → The current rao measures the ability to pay current liabilies with current assets → In general, a higher current rao indicates a stronger nancial posion • Quick Rao (Acid-Test Rao) 25 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng UCSC | Marna Marazzi → It tells us whether a business could pass the “acid test” of paying all its current liabilies if they came due immediately → Uses narrower base to measure liquidity than the current rao does → Rate of .90 to 1.00 is acceptable in most industries • Debt Rao This relaonship between total liabilies and total assets is called the debt rao, which gives an indicaon of the degree of leverage or gearing of a company. → The debt rao tells us the proporon of assets nanced with debt → A debt rao of 1 reveals that debt has nanced all the assets → A debt rao of 0.50 means that debt nances half the assets → The higher the debt rao, the greater the pressure to pay interest and principal, the lower the rao, the lower the risk (it can be also expressed as a percentage) • Times-Interest-Earned Rao Analysts use another rao—the mes-interest-earned rao (or interest coverage rao)—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 rao, divide income from operaons (operang income) by interest expense → It measures the number of mes operang income can cover interest expense and is also called the interest-coverage rao → A high rao indicates ease in paying interest; a low value suggests diculty – Protability raos The fundamental goal of a business is to earn a prot, and so the raos that measure protability are reported widely. Protability raos may be expressed in decimals or percentages. • Gross Prot, Operang Prot, and Net Prot Margin These raos show the percentage of each sales dollar earned as gross, operang, and net prot. If the company does not explicitly have a line on its Income Statement as operang prot (or prot from operaons), we can use earnings before interest and tax (EBIT) as a surrogate for operang prot. → Gross Prot Margin Percentage: it is the amount of prot enty makes from merely selling its products, before other operang costs are subtracted → Operang Prot Margin Percentage: it measures percentage of prot earned from sales in a company’s core business operaon • Return on Total Assets (ROA) → Measures a company’s success in using assets to earn a prot → The numerator is the net prot → 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 Accounng UCSC | Marna Marazzi → This rao shows the relaonship 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 raos • 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 stascs and it is the only rao that appears at the boom of the Income Statement and the only nancial rao that has an accounng 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 Rao (P/E) → It shows how much an investor is willing to pay for each unit of earnings → It appears in every nancial secon 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 accounng 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])