chapter 10 financial statement analysis. powerpoint slides t/a accounting: what the numbers mean...

CHAPTER 10Financial Statement Analysis

PowerPoint Slides t/a Accounting: What the Numbers MeanMarshall, McCartney, van Rhyn, McManus, VieleSlides prepared by Sandra Chapple Copyright 2005 McGraw-Hill Australia Pty Ltd

10-2

Overview

• Liquidity measures

• Activity measures

• Accounts receivable and inventory turnover

• Profitability measures

• Price earnings ratio and evaluation of share market price

• Dividend yield and dividend payout ratio

• Financial leverage

• Common size financial statements

• Other operating statistics


10-3

Financial Statement Ratios

Ratios are used to interpret the financial position and results of operations of an entity and may be grouped in the following four categories:

1.1. LiquidityLiquidity

2.2. ActivityActivity

3.3. ProfitabilityProfitability

4.4. Debt, or financial leverageDebt, or financial leverage


10-4

Liquidity Measures

The liquidity measures of working capital, current The liquidity measures of working capital, current ratios and quick ratios were discussed in ratios and quick ratios were discussed in Chapter 3.Chapter 3.

Remember: The effect of the inventory cost-flow assumption on:

FIFO

Specific identification

Weighted average

current ratios

and

working capital


10-5

Liquidity Measures

Suppliers and creditorsSuppliers and creditors

What is the firms current and recent payment experience?

Is the firm paying its bills promptly?

May be indicated by extent that cash discounts are being taken.


10-6

Activity Measures

Focus primarily on relationships between asset levels and net sales. The general model for calculating turnover is:

Turnover = Sales ÷ Average AssetsTurnover = Sales ÷ Average Assets

Average assets use balance sheet amounts reported at the beginning and end of a period.


10-7

Activity Measures

• accounts receivable

• inventories

• plant and equipment

• total operating assets

• total assets.

• accounts receivable

• inventories

• plant and equipment

• total operating assets

• total assets.

Turnover is often used in the calculation for assessing activity of:


10-8

Activity Measures

Turnover ratios will be affected by inventory cost-flow assumptions and depreciation methods:

Higher asset turnover Lower asset turnover

$ inventory $ depreciable assets

FIFO and accelerated depreciation

Weighted-average and straight line

depreciation

$ inventory $ depreciable assets


10-9

Activity Measures

Amounts for 2004

Cash 30,000$

Accounts receivable, net

Beginning of year 17,000

End of year 20,000

Inventory

Beginning of year 10,000

End of year 12,000

Total current assets 65,000

Total current liabilities 42,000

Sales 500,000

Cost of goods sold 140,000

These amounts

will be used to

demonstrate how

the ratios can be

calculated.


10-10

Accounts Receivable Turnover

SalesSalesAverageAverage Accounts ReceivableAccounts Receivable

Accounts Accounts ReceivableReceivableTurnoverTurnover

==

A measure of how many times a company converts A measure of how many times a company converts its receivables into cash each year.its receivables into cash each year.

A measure of how many times a company converts A measure of how many times a company converts its receivables into cash each year.its receivables into cash each year.

= 27.03 times= 27.03 times

== $500,000$500,000 ($17,000 + $20,000) ÷ 2($17,000 + $20,000) ÷ 2

Or average collection period of 13.5 days.


10-11

Inventory Turnover

Cost of Goods SoldCost of Goods Sold AverageAverage Inventory Inventory

InventoryInventoryTurnoverTurnover ==

A measure of the number of times merchandise A measure of the number of times merchandise inventory is sold and replaced during the year.inventory is sold and replaced during the year.

A measure of the number of times merchandise A measure of the number of times merchandise inventory is sold and replaced during the year.inventory is sold and replaced during the year.

= = 12.73 times12.73 times

$140,000$140,000 ($10,000 + $12,000) ÷ 2($10,000 + $12,000) ÷ 2

==


10-12

Inventory Turnover

Lower inventory compared to sales means less Lower inventory compared to sales means less needs to be financed by debt or equity.needs to be financed by debt or equity.

Lower inventory compared to sales means less Lower inventory compared to sales means less needs to be financed by debt or equity.needs to be financed by debt or equity.

BUT…BUT…• risk of not having enough inventory to meet risk of not having enough inventory to meet

demand demand • risk of out of stock situation with delay in risk of out of stock situation with delay in

receiving raw materials or finished product receiving raw materials or finished product

and and lost sales.lost sales.

BUT…BUT…• risk of not having enough inventory to meet risk of not having enough inventory to meet

demand demand • risk of out of stock situation with delay in risk of out of stock situation with delay in

receiving raw materials or finished product receiving raw materials or finished product

and and lost sales.lost sales.


10-13

Inventory Turnover

Inventory management systemInventory management systemInventory management systemInventory management system

JIT - Just in time:JIT - Just in time:

• Keep the investment in Keep the investment in

inventories at a minimum by inventories at a minimum by

forecasting needs.forecasting needs.

• Suppliers deliver inventories Suppliers deliver inventories

only when needed.only when needed.

JIT - Just in time:JIT - Just in time:

• Keep the investment in Keep the investment in

inventories at a minimum by inventories at a minimum by

forecasting needs.forecasting needs.

• Suppliers deliver inventories Suppliers deliver inventories

only when needed.only when needed.


10-14

Activity Measures

In evaluating the firm’s operating efficiency, it is the trend of these calculations over time that is important.


10-15

Profitability MeasuresDiscussed in Chapter 3:

• Return on assets (ROA)

• Return on equity (ROE).

Points to remember:

• ROA is based on EBIT (earnings before interest and tax)

• better measure of management activities as

• interest is a function of capital structure

• tax is a function of the tax laws.


10-16

Profitability MeasuresNeed to maintain healthy scepticism about:

True rate of return

True rate of return

ROA and ROE

ROA and ROE

relationship?

• Based on:

• real economic profit related to

• fair market values

No agreement on how to determine these


10-17

Profitability Measures

Evaluations more valid when based on the trend of one company’s ROA and ROE relative to:

Trends in industry

Trends of competitors


10-18

Price/Earnings Ratio

Price earningsPrice earningsratioratio

Market price per ordinary shareMarket price per ordinary share Earnings per shareEarnings per share==

Closing market price per share $4.10Earnings per share $0.13

Primary Health Care Ltd 30 June 2003

A measure often used by investors to evaluate the

market price of a company’s ordinary shares.

A measure often used by investors to evaluate the

market price of a company’s ordinary shares.

Price earningsPrice earningsratioratio

$4.10$4.10$0.13$0.13== = 32.7 times= 32.7 times


10-19

Price/Earnings Ratio

Market price of a share

Investors’ expectations about the firm’s future

earnings

Relating market price and earnings per share in a ratio (price earnings ratio) is a way to

express investors’ expectations

The greater the probability of increased earnings, the more investors are willing to

pay.


10-20

Price/Earnings RatioCompany A Company B

Market price per share $45.00 $63.00

Earnings per share $1.80 $3.50

Price / Earnings Ratio 25 18

At first glance, company B shares look more expensive,

but company A shares are more expensive as investors

are willing to pay 25 times earnings for the shares,

compared with 18 times for company B.


10-21

Dividend Yield

DividendDividendyieldyield

Dividends per shareDividends per share Market price per shareMarket price per share==

Closing market price of share 60.00$ Annual cash dividend 1.45

Cruisers Ltd 30 June 2006

Identifies the return, in terms of cash dividends, on the current Identifies the return, in terms of cash dividends, on the current market price of the shares.market price of the shares.

Identifies the return, in terms of cash dividends, on the current Identifies the return, in terms of cash dividends, on the current market price of the shares.market price of the shares.

$1.45$1.45 $60.00$60.00

== = 2.4%= 2.4%DividendDividend

YieldYield


10-22

Dividend Payout Ratio

DividendDividendpayout ratiopayout ratio

Annual dividend per shareAnnual dividend per share Earnings per shareEarnings per share==

Reflects the dividend policy of the company. Investors are able to project future dividends based on a company’s

earnings prospects.

Reflects the dividend policy of the company. Investors are able to project future dividends based on a company’s

earnings prospects.

DividendDividendPayout RatioPayout Ratio == = 25.7%= 25.7% $1.45$1.45

$5.64$5.64

Annual dividend per share 1.45$ Earnings per share 5.64

Cruisers Ltd 30 June 2006


10-23

Financial Leverage

Financial leverageFinancial leverage refers to the use of debt to refers to the use of debt to finance the assets of the entity.finance the assets of the entity.

Leverage adds risk - if there is not enough cash to pay principal and interest, entity may

be forced into bankruptcy.

BUT, as the cost of debt is fixed, leverage also magnifies the return to owners (ROE) relative

to the return on assets (ROA).


10-24

Financial Leverage

Borrowing at an interest rate that is less than the rate of return that can be earned on that

money, multiplies the return on owners’ equity.

Debt and preference shares provide leverage opportunities as the interest cost or dividend

rate is fixed.


10-25

Financial Leverage - Debt Ratio

Total liabilitiesTotal liabilities Total liabilities + Owners’ equityTotal liabilities + Owners’ equityDebt ratioDebt ratio ==

Measures the proportion of assets being provided by creditors.

Measures the proportion of assets being provided by creditors.

Debt ratioDebt ratio == = = 40%40% $40000$40000 $100000$100000

Total owners' equity 60,000

Total liabilities 40,000

Total liabilities plus owners' equity 100,000

Total owners' equity 60,000

Total liabilities 40,000

Total liabilities plus owners' equity 100,000


10-26

Financial Leverage - Debt/Equity Ratio

Debt/Equity Debt/Equity ratioratio ==

Total liabilitiesTotal liabilities Total owners’ equityTotal owners’ equity

Debt/Equity Debt/Equity ratioratio == = = 67.0%67.0% $40000$40000

$60000$60000

Measures the relative proportion of contribution from owner’s and creditor’s.

Measures the relative proportion of contribution from owner’s and creditor’s.


10-27

Financial Leverage - Times Interest Earned

A common measure of the ability of a firm to cover interest and provide protection to the long-term

creditors.

A common measure of the ability of a firm to cover interest and provide protection to the long-term

creditors.

Times interest Times interest earnedearned

== == 1.95 times1.95 times$6587$658733783378

Times interest Times interest earnedearned

Earnings before interest and taxesEarnings before interest and taxesinterest expenseinterest expense==

Net profit before income tax $3,209Add back interest expense $3,378EBIT $6,587

Cruisers Ltd 30 June 2006 ($000)


10-28

BALANCE SHEET

Current AssetsNon Current AssetsTOTAL ASSETS 100%

Current LiabilitiesNon Current LiabilitiesTOTAL LIABILITIES

OWNERS' EQUITY

TOTAL LIABILITIES AND OWNERS' EQUITY 100%

Common Size Financial Statements

Each asset expressed as a %

of total assets

Each liability and equity account

expressed as a % of total


10-29

Common Size Financial Statements

Each item on the Income

Statement expressed as a %

of total sales

This type of analysis makes spotting trends

easier.


10-30

Other operating statistics

Statistics other than financial ratios may be used to evaluate a firm.

• Sales in units

• Total number of employees

• Sales dollar per employee

• Operating income per employee

• Plant operating expenses per square metre of plant

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