Chapter 14Financial Statement Analysis

Who and Why? To understand the economics of a firm and To help forecast its future profitability and risk Managers

Responsible for day to day operations and long-run performance Responsible and accountable for efficiency, effective deployment of

capital, human resource and other resource management Owners

Interested in current and long-term returns on their investments Expect growing earnings, dividends Affected by how earnings are distributed and how their shares are

valued in the market Lenders and creditors

Concerned about liquidity and cash flow of the company Interested in the degree of financial leverage employed

Others: employees, government, society

Financial Statement Analysis Should start with an understanding of

Global and local macro economic condition Industry (past performance, future expectations,

competition etc…) Should involve time series analysis, Should compare performance with peers,

competitors, industry averages

Tools Analytical Analysis

Vertical Analysis Horizontal Analysis

Ratio Analysis

Analytical Analysis

Vertical Analysis Express the items in the financial statements as a

percentage of total assets or sales

Income Statement- Vertical AnalysisIncome Statement

01.01.2006- 31.12.2006

01.01.2005- 31.12.2005

01.01.2004- 31.12.2004

Sales Revenue 679.109.952 100% 533.179.059 100% 484.217.501 100%

Cost of Sales (494.829.354) -73% (384.957.208) -72% (334.949.677) -69%

Gross Profit 184.280.598 27% 148.221.851 28% 149.267.824 31%

Operating expenses (109.625.499) -16% (64.064.255) -12% (59.149.709) -12%

Operating income 74.655.099 11% 84.157.596 16% 90.118.115 19%

Other income 42.965.316 6% 21.707.341 4% 29.896.364 6%

Other expense (69.646.923) -10% (33.921.481) -6% (23.463.677) -5%

Financial expenses, net (19.455.362) -3% (7.271.009) -1% (10.447.308) -2%

Income before monetary loss and taxes28.518.130 4% 64.672.447 12% 86.103.494 18%

Loss on monetary position 0 0% 0 0% (5.603.281) -1%

Minority Interest (1.978.179) 0% 894.625 0% (2.388.309) 0%

Income before taxes 26.539.951 4% 65.567.072 12% 78.111.904 16%

Tax expense 10.485.947 2% (12.359.914) -2% (17.031.347) -4%

Net Income 37.025.898 5% 53.207.158 10% 61.080.557 13%

Earnings per share 0,2445 0,3514 0,4034

Balance Sheet Vertical Analysis

Balance Sheet 12.31.2006 2006 31.12.2005 2005 31.12.2004 2004AssetsCurrent Assets 323.005.585 26% 270.115.547 26% 212.197.885 27%Cash and cash equivalents 68.780.065 6% 74.834.352 7% 49.026.423 6%Trading securities, net 52.842 0% 100.156 0% 25.755 0%Trade receivables, net 74.261.814 6% 53.030.694 5% 40.472.344 5%Due from related parties, net 19.179.748 2% 43.892.285 4% 50.714.258 6%Other receivables, net 36.018.789 3% 23.747.722 2% 18.484.620 2%Inventories, net 124.425.343 10% 74.411.768 7% 52.128.304 7%Other current assets 286.984 0% 98.570 0% 1.346.181 0%Long-term assets 905.421.795 74% 777.097.920 74% 587.857.590 73%Trade receivables, net 11.734 0% 61.484 0% 21.288 0%Due from related parties, net 0% 10.250 0%Financial assets, net 118.236.407 10% 101.513.970 10% 68.170.577 9%Goodw ill 13.181.689 1% 16.249.281 2% 4.196.133 1%Property plant & equipment, net 760.036.354 62% 653.345.452 62% 515.019.808 64%Intangible assets, net 816.222 0% 378.815 0% 439.534 0%Deferred Tax Assets 13.139.389 1% 5.548.918 1%Total assets 1.228.427.380 100% 1.047.213.467 100% 800.055.475 100%

LiabilitiesCurrent liabilities 273.773.294 22% 189.106.987 18% 104.017.119 13%Financial liabilities 111.909.791 9% 59.274.699 6% 39.619.889 5%Current portion of long-term debt 66.179.457 5% 27.725.877 3% 13.899.645 2%Other f inancial liabilities, net 9.974.767 1% 9.661.133 1% 7.131.426 1%Trade payables 31.376.464 3% 45.300.618 4% 13.294.594 2%Due to related parties 46.244.139 4% 44.590.564 4% 23.351.021 3%Advances received 1.022.139 0% 852.778 0% 1.459.347 0%Accrued expenses 674.264 0% 163.255 0% 288.234 0%Other liabilities 6.392.273 1% 1.538.063 0% 4.972.963 1%Long-term liabilities 254.733.661 21% 213.920.436 20% 125.084.120 16%Financial liabilities 204.283.035 17% 152.063.743 15% 71.323.248 9%Provisions 19.748.369 2% 19.032.720 2% 16.458.811 2%Deferred tax laibilitity 30.702.257 2% 42.782.723 4% 37.052.488 5%Other liabilities 0 0% 41.250 0% 249.573 0%Minority Interest 66.778.345 5% 40.198.563 4% 39.237.953 5%Shareholders' Equity 633.142.080 52% 603.987.481 58% 531.716.283 66%Share Capital 151.431.691 12% 151.431.691 14% 151.431.691 19%Capital reserves 344.775.869 28% 327.475.774 31% 304.246.330 38%Additional paid in capital 35 0% 35 0% 35 0%Financial asset reserve 47.011.512 4% 29.711.417 3% 6.481.973 1%Inflation adjsutment 297.764.322 24% 297.764.322 28% 297.764.322 37%Profit reserves 63.858.215 5% 60.696.208 6% 52.177.043 7%Legal reserves 13.541.041 1% 9.581.837 1% 6.823.524 1%Special reserves 1.259.266 0% 549.568 0% 25.125 0%Extraordinary reserves 45.017.611 4% 44.278.183 4% 44.001.350 5%Foreign currency translation reserve 4.040.297 0% 6.286.620 1% 1.327.044 0%Net Income for the year 37.025.898 3% 53.207.158 5% 61.080.557 8%Retained Earnings (accumulated loss) 36.050.407 3% 11.176.650 1% (37.219.338) -5%Total equity and liabilities 1.228.427.380 100% 1.047.213.467 100% 800.055.475 100%

Analytical Analysis Vertical AnalysisVertical Analysis

Express the items in the financial statements as a Express the items in the financial statements as a percentage of total assets or salespercentage of total assets or sales

Horizontal Analysis A base year is selected and the changes overtime are

expressed as percentage of the base year Annual percentage changes are computed

Balance Sheet 2006 2005 2004 2003AssetsCurrent Assets 174% 145% 114% 100%Cash and cash equivalents 291% 316% 207% 100%Trading securities, net 63% 120% 31% 100%Trade receivables, net 340% 243% 186% 100%Due from related parties, net 24% 55% 63% 100%Other receivables, net 336% 221% 172% 100%Inventories, net 250% 150% 105% 100%Other current assets #DIV/0! #DIV/0!Long-term assets 164% 141% 106% 100%Trade receivables, net 23% 120% 42% 100%Due from related parties, net #DIV/0! #DIV/0!Financial assets, net 191% 164% 110% 100%Goodw ill 77% 95% 24% 100%Propertt plant & equipment, net 161% 138% 109% 100%Intangible assets, net 178% 83% 96% 100%Deferred Tax AssetsTotal assets 166% 142% 108% 100%

Ratio Analysis Important point: to be selective-too many ratios would lead to

information overload Understand the meaning and limitations of the ratios Define the following elements before starting:

The viewpoint taken The objectives of the analysis The potential standards of comparison

Usefulness of Ratios Help compare different firms, and Help compare the firm against its past performance Standards against which to compare ratios

1. The planned ratio for the period

2. The corresponding ratio from a prior period

3. The corresponding ratio for another firm in the same industry

4. The average ratio for other firms in the same industry

Ratio Analysis Categories Activity (operations and asset management) Liquidity (meeting short-term obligations) Solvency (meeting long-term obligations) Profitability (earnings and cost coverage) Cash Flow (quality of earnings) Price Multiples (stock price)

Activity Ratios Receivable turnover

Average collection period

sreceivable tradeAverage

net sales,Credit

turnoverreceivable

365

Activity Ratios Inventory turnover

Average days in inventory

sinventorie average

sold goods ofCost

turnoverinventory

365

Activity Ratios Payable Turnover

Average payment period

payables tradeAverage

sinventoriein COGS

turnoverpayable

365

Activity Ratios Cash Cycle:

periodpayment -inventory in days period Collection

Activity Ratios PP&E Turnover

Asset Turnover

E&PP Average

SalesNet

assets Average

SalesNet

Activity Ratios- SummaryReceivable Turnover Net Sales/Average Trade ReceivablesInventory Turnover COGS/Average InventoriesPayable Turnover Purchases/Average Trade PayablesPP&E Turnover Net Sales/Average PP&EAsset Turnover Net Sales/Average total assets

Average collection period 365/receivable turnover Average days in inventory 365/inverntory turnoverAverage payment period 365/payable turnover

Cash cycle= collection period + days in inventory -payment period

Activity Ratios 2007 2006 2005 2004Receivable Turnover 10,62 10,67 11,40 15,55 Inventory Turnover 4,84 4,98 6,08 6,57 Payable Turnover 17,75 14,21 13,90 25,24 PPE Turnover 1,13 0,96 0,91 0,98 Asset Turnover 0,71 0,60 0,58 0,63

Collection Period 34,37 34,21 32,00 23,47 Days in inventory 75,48 73,33 59,99 55,52 Payment period 20,57 25,68 26,26 14,46

Cash cycle 89,29 81,86 65,74 64,54

A. Cam

Liquidity Ratios Current ratio

Ability to meet short-term obligations [Current assets/current liabilities]

Quick ratio Remove less liquid assets Keep cash, liquid investments, A/R [(Cash+short-term investments + A/R)/current liabilities]

Liquidity Ratios

Short term liquidity 2007 2006 2005 2004Current Ratio 1,13 1,18 1,43 2,04 Quick Ratio 0,48 0,52 0,68 0,86

Solvency Ratios Debt to assets: Total liabilities/Total assets

Proportion of assets financed with debt Could include interest bearing debt only

[(short term debt + noncurrent debt)/total assets] Be aware that assets are recorded at historical

cost, which may be different from current market value

Solvency Ratios Debt to equity: Total liabilities/Total equity

A measure of how assets are financed

Solvency RatiosCoverage Ratios

Adequacy of resources for meeting firm’s contractual obligations

Times interest earned Can the firm cover its interest obligations? (EBIT/Interest expense)

Cash interest coverage (Cash from ops + interest paid + tax paid)/Interest paid

Solvency RatiosDebt to assets Total liabilities/Total assets Debt to equity Total liabilities/Total equity Times interest earned EBIT/Interest expense

Long-term Liquidity 2007 2006 2005 2004Debt ratio 0,43 0,43 0,38 0,29 debt to equity 0,86 0,83 0,67 0,43 Times interest earned 5.04 3,84 11,57 8,63

Profitability Ratios Gross Margin: profitability of sales Return on Sales: Net profitability of the

company

net Sales,

IncomeNet Saleson Return

net Sales,

Profit Gross %Margin Gross

Profitability Ratios Retun on Assets Return on Equity

ROA = Net Income/ Average Total Assets

ROE = Net Income/Average SH's Equity

Profitability RatiosProfitability RatiosGross Margin Gross profit/Sales revenue Return on Sales Net Income/Sales revenue Return on Assets Net income/Average total assets Return on Equity Net income/Average total equity

Profitability 2007 2006 2005 2004Gross margin % 27,36% 27,14% 27,80% 30,83%Net Profit Margin 7,91% 5,45% 9,98% 12,61%ROA = 5,60% 3,25% 5,76% 7,94%ROE = 10,99% 5,99% 9,37% 11,96%

A. Cam

Cash Flow RatiosQuality of earnings

Ability to pay obligations CFO/Total liabilities CFO = Cash flows from operations

Profitability (cash flow relative to sales) CFO/Sales revenue

Cash flow-earnings index CFO/Net income

Cash Flow RatiosAbility to Pay Obligations CFO/Total liabilities Cash Flow relative to Sales CFO/Sales revenue Cash flow-earnings index CFO/Net income

Cash flow 2007 2006 2005 2004Ability to pay obligations 0,32 0,15 0,37 0,50 Cash flow relative to sales 0,20 0,12 0,28 0,24 cash flow earnings index 2,52 2,21 2,77 1,86

Price Multiple Ratios Market’s valuation of a firm’s common stock

P/E = Share price/Earnings per share Price/book ratio compares stock’s price to the

recorded value of the net assets[Share price/(Book value of equity/Share outstanding)]

Market Ratios 2007 2006 2005 2004Price earnings ratio 12,73 46,67 16,93 11,16price to book value 1,35 1,34 1,49 1,28

Limitation of Ratio Analysis

Represent the average conditions and influenced by the accounting methods used

Based on historical data and do not reflect price level effects and real economic values

Changes in many ratios are strongly associated with each other and interrelationships among/between the ratios should be examined

During comparison of ratios over a period of time changes in operating conditions should be taken into consideration

During comparison between companies differences among the companies should be examined

Use audited financial statements to perform ratio analysis

Analysis of Anadolu Cam The changes in total assets and total liabilities over the period

confirm the company’s investments that started in 2005. During the period the following changes in total assets and total sales were realized:

Change in total assets From 2004 to 2005 31% From 2005 to 2006 17% From 2006 to 2007 5% Change in total sales From 2004 to 2005 10% From 2005 to 2006 27% From 2006 to 2007 31%

After the realization of investments, profitability of the company showed a decline which caused fluctuations in net income.

The growth in total sales lagged behind the growth in total assets which is generally expected in times of investments. The efficiency of assets should be investigated by the help of turnover ratios in the ratio analysis.

The proportion of total current assets to current liabilities has been changing in favor of current liabilities which require further analysis for short term liquidity.

Long-term assets are mainly funded by shareholders’ equity and long-term liabilities which is preferable for long-term solvency. However, the composition of long-term funds is changing over the years in favor of the liabilities.

The composition of total assets didn’t change a lot over the years presented, although there are slight changes within the composition of current assets. This requires further investigation in ratio analysis.

Activity Ratios All activity ratios for operating items have been decreasing. Both

accounts receivable and inventory turnover ratios decreased considerably after 2005 (after the investment): This may be a result of higher working capital requirements of the new investment, or a general trend in the industry. Furthermore, accounts payable turnover increased in 2007 although no improvements are observed for receivables and inventories. These are expected to increase the need of working capital requirements of the company. In other words, the increase in cash cycle to 89 days requires additional funding for the company. When the increase in financial liabilities from 2005 to 2006 is considered (90%), one can conclude that the company financed the working capital investments by short term financial liabilities.

The decreases in turnover rates for accounts receivable and inventories and the increase in the accounts payable turnover is a future threat for the short term liquidity of the company.

Activity Ratios The performance in the PPE and total asset

turnover is as expected. After the investments PPE turnover together with the total asset turnover declined (for 2005 and 2006). Such turnover rates improved in 2007 when the investments were completed.

Short term Liquidity Short-term liquidity ratios of the company had been decreasing since

2005. This may be a result of making investments. Both the current and the quick ratios are below the rule of thumb ratios of 2 and 1, respectively.

There is a considerable difference between the current and the quick ratio. This is normally an indication of inventory dependence. When one checks the level of inventories and the increase in inventories, it seems that inventory account has been growing. As the inventory turnover of the company is decreasing over the years, we can conclude that short term liquidity of the company is alarming. As of the last reporting date, it seems that the company may not be able to pay its current liabilities with its most quick assets. In addition, because of the decreases in inventory, current assets may also not be sufficient to meet the current liabilities.

Long-term Solvency Both the debt ratio and the debt to equity ratio are at the acceptable levels. Under normal

conditions debt ratio of 50% is deemed to be optimal for the financial risk of the company. The debt ratio started to increase in 2005 after the investments. This means that the company

financed its investments by using liabilities. Since these liabilities are long-term, they shouldn’t adversely affect the risk. Also, by using liability funding the company is expected to enjoy financial leverage. As of the end of the last reporting period, the company doesn’t seem to have a long-term solvency problem. It has a healthy financial structure.

Times interest earned is used by creditors to assess the ability to make interest payments from the earnings of the company. Until 2006, interest coverage performance of the company was very successful. However, starting with 2006, both the short term and long term financial liabilities increased, and so the financial expenses. In addition in 2006, as will be explained in the profitability analysis, operating income of the company declined significantly. All the above mentioned factors caused times interest earned ratio to decline. However, we should also note that the ratio recovered in 2007 as a result of recovery in profitability. Although it would better to have a higher coverage ratio, we believe the current performance of the company does not raise a red flag at the moment.

Profitability To assess the company’s performance in terms of profitability we should also use the ratios of a similar

company as we should for the activity ratios. Over the years the company’s profitability declined until 2007. Especially in 2006 both the operating

margin and the net profit margin had declined significantly. One of the reasons of such decrease could be the increase in fixed costs of the company after making the investment. When one analyses the income statement and the related notes to the financial statements there are three important reasons for the decreasing profits of 2006: Within the operating expenses, selling expenses increased a lot, which may be due to marketing efforts after the

capacity increase. These expenses declined in the following year. Secondly, the company had approximately YTL19.000 of losses from sale of property, plant and equipment. In 2006

after the new investment, the company might have disposed of old equipment. Losses on sales of PPE are not continuing expenses therefore; they are not expected to adversely affect profitability in the future.

The third reason of the decrease in profitability in 2006 is the 170% increase in the financial expenses as a result of the increase in the borrowings during the same period. Financial expenses continue to increase in 2007, however, as total sales also increased, percent of financial expenses within sales is constant.

The company’s ROE and ROA had sharp decreases in 2006. Such a sharp decrease in that year had two reasons: First because of the reasons explained above, net income decreased. Second is the growth in assets and shareholders’ equity. The decrease in ROA is sharper because of the increase in the assets. Both ratios recovered back in 2007, although they didn’t reach their previous levels.

In summary, although the company’s profitability ratios declined after the investment, improvements had started in 2007. If the sales of the company continue to increase, profitability performance of the company doesn’t raise any red flags.

Cash Flow Performance The company had been generating positive operating

cash flows for the last four years, and the cash flow index is more than 2 over the same period. Therefore there doesn’t seem to be a earnings quality problem.

During 2006 the company had positive cash flows from operating and financing activities. Investments were mostly financed by liabilities. In 2007 cash flows from financing activities was also negative. The company started to pay back the liabilities. It also continued to pay dividends, although not as much as the previous year.

Market Ratios Price earnings ratio of the company was

considerably high in 2006, which was probably due to lower earnings at that year. It declined in 2007 for two reasons: First the earnings increased, second share price declined. We should check the PE ratios and the market performance of other companies as well to comment on the decrease of the share price.

However, the fact that the company increased its share capital by issuing free shares from the inflation adjustment might have caused the share price to decrease.

Conclusion Except for the short term liquidity, the company’s financial position and

performance is satisfactory. However before making any concluding remarks, we should also compare the results of this analysis with industry averages and/or a similar company.

Future success of the company is dependent on the continuing increase in the growth of sales revenues. 2009 is a period for which growth in the economy and in many other industries is not very promising, therefore the company may face difficulties in increasing its sales. And if the sales do not increase as expected the company’s future earnings may be at stake. Furthermore, the company’s short term liquidity is currently dependent on sustainable short term bank loans. If banks call back the loans and/or don’t give additional loans, the company may not be able to pay back its liabilities.

One more point to be considered is the group within which the company operates. It’s a part of Şişecam which is owned by İşbank. Its shareholders are currently very powerful in the market. Furthermore, the company is the largest in its area. One adverse point about the future of the company, is the fact that its second market is Russia, where the economy is not going very well.

Recommendations It is not advisable to provide a short term loan for the company.

However, from the perspective of a current short term creditor, calling back the loan also doesn’t seem to be a good choice, as loans may not be ultimately paid back if called early. For a new creditor it wouldn’t be wise to give a new short term loan.

The company’s financial structure is sound. It generates profits and operating cash flows. Therefore, a long-term loan may be provided.

As an investor, ignoring the current market conditions, Anadolu Cam may be a good investment alternative. The company is profitable and paying dividends. Furthermore, its PE ratio has declined in the previous year. It can be expected to increase in the future. However, if the stock market is expected to decline due to general economic conditions, investing in a stock may not be a good idea from a short-term perspective. If the investor has long-term investment goals, Anadolu Cam shares may be purchased.