Analyzing Financial Data and Ratios
Mr. Michael Wong
Lecturer, PolyU HKCC
Value of Financial Statement Analysis Financial statements, by their nature, are backward-
looking So why analyze the statements?
Analysis provides knowledge of a firm’s operating and financial structure
This aids in estimating future returns
Major Financial Statements Corporate annual reports must include:
Statement of Financial Position Income statement Statement of cash flows
Enough for analysis?
Purpose of Financial Statement Analysis Evaluate management performance in
Profitability Efficiency Risk
Although financial statement information is historical, it is used to project future performance
Five Categories of Financial Ratios1. Common size statements
2. Internal liquidity (solvency)
3. Operating performance Operating profitability Operating efficiency
4. Risk analysis Business risk Financial risk
5. Growth analysis
Common Size Statements Normalize balance sheets and income statement
items to allow easier comparison of different size firms
A common size balance sheet expresses accounts as a percentage of total assets
A common size income statement expresses all items as a percentage of sales
Consolidated Statement of Income
Consolidated Statement of Financial Position
Evaluating Internal Liquidity Internal liquidity (solvency) ratios indicate the
ability to meet future short-term financial obligations Current Ratio Quick Ratio Cash Ratio
Evaluating Operating Performance Ratios that measure how well management is
operating a business Operating profitability ratios
Examine how management is doing at controlling costs so that a large proportion of the sales dollar is converted into profit
Operating efficiency ratios Examine how management uses its assets to generate
sales; considers the relationship between various asset categories and sales
Operating Profitability Ratios Operating profitability
ratios measure Gross profit margin Operating profit margin Net profit margin Return on owner’s
equity (ROE)
Operating Efficiency Ratios How effectiveness of a firm’s use of its total
asset base to produce sales Total asset turnover Non-current asset turnover Operating cycle Cash conversion cycle
Operating Cycle & Cash Conversion Cycle
TimeAccounts payable period
Cash conversion cycle
Operating cycle
Cash received
Accounts receivable periodInventory period
Finished goods sold
Firm receives invoice Cash paid for materials
Order Placed
Stock Arrives
Raw material purchased
Operating Profitability Ratios Return on owner’s equity (ROE) indicates the
rate of return earned on the capital provided by the stockholders after paying for all other capital used
Equity Total Average
IncomeNet Equity Totalon Return
Operating Profitability Ratios The DuPont System divides ROE into several
ratios that collectively equal ROE while individually providing insight
An extended DuPont System provides additional insights into the effect of financial leverage on the firm and pinpoints the effect of income taxes on ROE
Operating Profitability Ratios
EquityCommon
Assets Total
Assets Total
Sales
Sales
IncomeNet
EquityCommon
IncomeNet
Profit Total Asset Financial
Margin Turnover Leverage= xx
Risk Analysis Risk analysis examines the uncertainty of income for
the firm and for an investor Total firm risks can be decomposed into two basic
sources: Business risk: The uncertainty in a firm’s operating
income, highly influenced by industry factors Financial risk: The added uncertainty in a firm’s net
income resulting from a firm’s financing decisions
Business Risk Variability of the firm’s operating income over timeTwo primary determinants of business risk Sales variability
The main determinant of earnings variability Cost Variability and Operating leverage
Production has fixed and variable costs Greater fixed production costs cause greater profit
volatility with changes in sales Fixed costs represent operating leverage Greater operating leverage is good when sales are high
and increasing, but bad when sales fall
Effect of operating leverage More operating leverage leads to more business
risk, for then a small sales decline causes a big profit decline.
What happens if variable costs change?
Sales
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FC
QBE Sales
$ Rev.
TCFC
QBE
} Profit
Financial Risk Interest payments are deducted before we get
to net income These are fixed obligations
Similar to fixed production costs, these lead to larger earnings during good times, and lower earnings during a business decline Fixed financing costs are called financial leverage
The use of debt financing increases financial risk and possibility of default
Financial Risk Two sets of financial ratios help measure
financial risk Balance sheet ratios Earnings or cash flow available to pay fixed
financial charges Acceptable levels of financial risk depend on
business risk A firm with considerable business risk should
likely avoid lots of debt financing
Financial Risk Balance Sheet Ratios
Total debt ratio Debt-equity ratio Equity multiplier
Earnings or cash flow available to pay fixed financial charges Times interest earned ratio Cash coverage ratio
Potential Growth Analysis Important to both creditors and owners
ability to pay future obligations Ability to pay dividends
g = ROE x Retention rate The retention rate is one minus the firm’s dividend
payout ratio Anything that impacts ROE would also be a
determinant of future growth
Importance of Relative Financial Ratios In order to make sense of a ratio, we must compare it
with some appropriate benchmark or benchmarks Examine a firm’s performance relative to:
The aggregate economy Its industry or industries Its major competitors within the industry Its own past performance (time-series analysis)
Comparing to the Aggregate Economy Most firms are influenced by economic
expansions and contractions in the business cycle
Analysis helps you estimate the future performance of the firm during subsequent business cycles
Comparing to the Industry Norms Most popular comparison Industries affect the firms within them differently,
but the relationship is always significant The industry effect is strongest for industries with
homogenous products Can also examine the industry’s performance
relative to aggregate economic activity
Comparing to the Firm’s Major Competitors Industry averages may not be representative A firm may operate in several distinct industries Several approaches:
Select a subset of competitors for the comparison group Construct a composite industry average from the different
industries in which the firm operates
Comparing to the Firm’s Own Past Performance Determine whether it is progressing or
declining Helpful for estimating future performance Consider trends as well as averages over time
Other than financial statements Corporate Profile Chairman’s Statement Management Discussion and Analysis Notes to Financial Statements
Segment information Noncurrent assets component Any commitments, etc.
Government & Industry Statistics Your Observation
Is financial performance everything? Financial performance may lead
management’s emphasis on short-run financial performance
Need to have some measures that translate an organisation’s mission and strategy into a comprehensive set of performance measures.
Other perspectives Four key perspectives:1 Financial2 Customer3 Internal business processes4 Learning and growth
Other perspectives Because the non-financial and operational indicators
measure fundamental changes that a company is making.
The financial benefits of these fundamental changes may not be captured in short-run earnings.
Strong improvements in non-financial measures signal the prospect of creating economic value in the future.
Q&A
Summary of Ratio analysis