topic 10 financial statement analysis

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TOPIC 10:

FINANCIAL STATEMENT ANALYSIS

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Introduction

Interpretation is when users evaluate financial information to make judgements

It is the key to any in-depth understanding of an organisation’s performance.

Basically, the users evaluate an organisation’s performance and financial position using the information from INCOME STATEMENT and BALANCE SHEET.

The value of the analysis is depends on the value of the financial statements.

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Techniques (types) of analysis:

1.Horizontal Analysis Comparing key figures in financial statement Evaluates a series of financial statement over a

period of time.

2. Vertical Analysis Evaluates financial statement by expressing each

item in a financial statement as a percent of the base amount (key figure)

Key-figure (such as sales in IS and total assets on BS) are set to 100%

Other items are then expressed as percentage of 100

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Techniques (types) of analysis: (cont.)

3. Trend analysis Similar to horizontal analysis, except

that the first set of account in the series is given a base of 100

4.Ratio Analysis It expresses the relationship among

selected items of financial statement data.

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Horizontal AnalysisHorizontal Analysis

What is horizontal analysis?

What is horizontal analysis?

It’s an analysis of the percentage increases and decreases of related items in comparative

financial statements.

It’s an analysis of the percentage increases and decreases of related items in comparative

financial statements.

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HOME DEPOTComparative Balance Sheets (in Millions)

Dec 31, 2006 and Dec 31, 2007

AssetsCurrent assets $10,361 $ 7,777 $2,584 33.2%Property and equipment, net 15,375 13,068 2,307 17.7Other assets 658 540 118 21.9Total assets $26,394 $21,385 $5,009 23.4

LiabilitiesCurrent liabilities $ 6,501 $ 4,385 $2,116 48.3Long-term debt, excluding current installment 1,250 1,545 (295) (19.1)Other long-term liabilities 372 256 116 45.3Deferred income taxes 189 195 (6) (3.1)Total long-term liabilities $ 1,811 $ 1,996 $ (185) (9.3)Total liabilities $ 8,312 $ 6,381 $1,931 30.3

Increase (Decrease)

Dec 31, 2007 Dec 31, 2006 Amount Percent

14-7

The stockholders’ equity section is not displayed.The stockholders’ equity section is not displayed.

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14-8

Horizontal Analysis:

Difference $2,584

Base year $7,777= 33.2%

33.2%

HOME DEPOTComparative Balance Sheets (in Millions)Dec 31, 2006 and Dec 31, 2007 Increase (Decrease)


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Dec 31, 2006 and Dec 31, 2007

14-9

Condensed

33.2% AssetsCurrent assets $10,361 $ 7,777 $2,584 33.2%Property and equipment, net 15,375 13,068 2,307 17.7Other assets 658 540 118 21.9Total assets $26,394 $21,385 $5,009 23.4


17.733.2%


Difference $2,307

Base year $13,068= 17.7%

Increase (Decrease)


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Dec 31, 2006 and Dec 31, 2007

14-10

Condensed



Increase (Decrease)


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HOME DEPOT INC. Income Statement (in millions)For Periods Ended December 31, 2007 and December 31, 2006

Sales (net) $53,553 $45,738 $7,815Cost of merchandise sold 37,406 32,057 5,349 Gross profit $16,147 $13,681 $2,466 Selling and store operating exp. 10,280 8,655 1,625General and administrative exp. 935 835 100 Total operating expenses $11,215 $ 9,490 $1,725Income from operations $ 4,932 $ 4,191 $ 741Other income and expenses:

Interest and investment inc. 53 47 6 Interest expense (28) (21) (7)Income before income tax $ 4,957 $ 4,217 $ 740 Income taxes 1,913 1,636 277 Net income $ 3,044 $ 2,581 $ 463


Difference $7,815

Base year $45,738= 17.1%

17.1%

14-11

Increase (Decrease)


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Difference $5,349

Base year $32,057= 16.7

17.1%16.7

14-12

Increase (Decrease)


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17.1%16.7

14-13

18.018.812.018.217.7

12.833.317.516.917.9

Increase (Decrease)


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Vertical AnalysisVertical Analysis

A percentage analysis can be used to show the relationship of each component to a total within

a single statement.

A percentage analysis can be used to show the relationship of each component to a total within

a single statement.

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The total, or 100% item, on the balance sheet is “total

assets.”

The total, or 100% item, on the balance sheet is “total

assets.”

Vertical AnalysisVertical Analysis

The total, or 100% item, on the income statement is

“total sales.”

The total, or 100% item, on the income statement is

“total sales.”

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14-18

AssetsCurrent assets $10,361 $ 7,777Property and equipment, net 15,375 13,068Other assets 58 540Total assets $26,394 $21,385

LiabilitiesCurrent liabilities $ 6,501 $ 4,385Long-term liabilities 1,811 1,996Total liabilities $ 8,312 $ 6,381 Stockholders’ EquityCommon stock/paid-in capital $ 5,529 $ 4,926RE & accumulated comp. loss 12,553 10,078Total stockholders’ equity $18,082 $15,004Total liabilities and SE $26,394 $21,385

Total assets is 100.0%


100.0%


December 31, 2007 and December 31, 2006

December 31, 2007 December 31, 2006 Amount Percent Amount Percent

14-18

Condensed

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14-19

Condensed



39.3%

100.0%

Vertical Analysis:

Current assets $10,361

Total assets $26,394= 39.3%

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14-20

Condensed



39.3%58.2

2.5100.0%

24.6% 6.9

31.5%

20.9% 47.6 68.5%100.0%

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14-21

Condensed

39.3%58.2

2.5100.0%

24.6% 6.9

31.5%

20.9% 47.6 68.5%100.0%

100.0%





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Condensed



39.3%58.2

2.5100.0%

24.6% 6.9

31.5%

20.9% 47.6 68.5%100.0%

100.0%

36.4%

Vertical Analysis:

Current assets $7,777

Total assets $21,385= 36.4%



14-22

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Condensed



39.3%58.2

2.5100.0%

24.6% 6.9

31.5%

20.9% 47.6 68.5%100.0%

100.0%

36.4%61.1

2.5



14-23

20.5% 9.3 29.8%

23.0% 47.1 70.2%100.0%

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Sales (net) $53,553 100.0% $45,738 100.0%Cost of merchandise sold 37,406 32,057Gross profit $16,147 $13,681Selling and store operating exp. 10,280 8,655General and administrative exp. 935 835Total operating expenses $11,215 $ 9,490Income from operations $ 4,932 $ 4,191Other income and expenses:

Interest and investment inc. 53 47 Interest expense (28) (21) Income before income tax $ 4,957 $ 4,217Income taxes 1,913 1,636Net income $ 3,044 $ 2,581

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Amount Percent Amount Percent

2007 2006

Net sales is 100.0%

Net sales is 100.0%

Net sales is 100.0%

Net sales is 100.0%

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14-25


2007 2006

Vertical Analysis:

Cost of Merchandise Sold $32,057

Net Sales $45,738

= 70.1%

2006

70.1

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Vertical Analysis:

Cost of Merchandise Sold $37,406

Net Sales $53,553

= 69.9%

2007


14-26


2007 2006

69.9 70.1

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14-27


2007 2007

69.9 29.9%

18.9% 1.8

20.7%9.2%

0.1 (0.1)

9.2% 3.6

5.6%

70.1

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14-28


2007 2006

70.1 30.1%

19.2%

1.7

20.9%

9.2%

0.1

(0.0)

9.3%

3.6

5.7%

29.9%

18.9% 1.8

20.7%

9.2%

0.1 (0.1)

9.2% 3.6

5.6%

69.9

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Types of ratio analysis

1. Profitability Ratio

2. Efficiency/activity/asset management Ratio

3. Liquidity Ratio

4. Solvency Ratio

5. Cash flow

6. Investment

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1. Profitability

1. Return on capital

employed

2. Gross profit ratio

3. Net profit ratio

2. Liquidity

1. Current ratio

2. Quick ratio

3. Efficiency

1. Debtors turnover

2. Debtors collection period

3. Stock turnover ratio

4. Asset turnover ratio

4. Solvency/financial leverage management ratio

1. Debt to Equity ratio

2.Debt ratio

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Continue………..

5. Cash Flow

1. Cash flow ratio

6. Investment 1. Dividend yield 2. Dividend cover 3. Earnings per share 4. Price/earnings ratio 5. Interest cover

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Importance of Ratios

Quick and easy snapshot of an organisation’s achievements

Aid for comparisonsRatio provide benchmark to compare on

company with another (inter-firm comparison) or to compare the same company over period of time (intra-firm comparison).

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PROFITABILITY RATIO

It measures the income or operating effectiveness of an organisation for a given period of time.

A low value of this ratio will affect the company ‘s ability to obtain debt, equity financing and the ability to grow or expand.

i Return on capital employed (ROCE)• measures effective use of capital• It measures the profitability from the

shareholder view point. It shows how many ringgit of the net income

were earned for each ringgit invested by the owner.

= Profit or earning after tax x 100%

Average capital employed

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Continue…ii. Gross Profit Margin It measures the percentage of one ringgit of sales

that results in gross income.= Sales – Cost of Goods Sold x

100% Sales= Gross Profit x 100%

Sales

iii. Net Profit MarginIt measures the percentage of one ringgit of sales that results in net income.= Profit or earning after tax x 100%

Sales

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LIQUIDITY RATIO

It measure the short term ability of the organisation to pay debt and to meet unexpected need for cash.

i. Current Ratio To measure the ability of current

asset that the company have to pay back the short term debt.

= Current Asset Current Liability

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ii. Quick Ratio• It measures the company’s immediate short

term liquidity.

Current Asset – Stock – Prepayment

Current Liability

Continue…

This ratio indicates whether current liabilities could be paid without having to sell the inventory

This ratio is useful for companies which cannot convert inventory into cash quickly if necessary.

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Cont…. This ratio indicates whether the business has

enough short-term assets to cover its short-term liabilities.

A ratio above 1 indicates that working capital is positive (Current assets exceed current liabilities)

A ratio below 1 indicates that working capital is negative.

Many large companies regularly operate with current ratio closer to 1 and 2

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Generally the higher the ratio, the greater the financial stability and the lower the risk for both creditors and owners.

However, the ratio should not be too high because that may indicate that the business is not reinvesting in long-term assets to maintain future productivity.

High current ratio can actually indicate problems if inventories are getting larger than they should be or collections of receivables are slowing down.

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EFFICIENCY RATIO

Debtors turnover Measures how many times it takes

customers to pay

Credit sales

Average debtors

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EFFICIENCY RATIO1. Debtors collection period Measures how long it takes customers to pay

= Average debtors x 365 days OR 365 days Credit sales debtors turnover

This ratio indicates how many days it takes, on average to collect a day’s sale revenue.

The quicker a business collects and bank the money, the better it is to the company

Large numbers of days is a negative signal, raising questions about the company’s policies of granting credit such as; Unrestricted credit policies Longer credit limit Collection attempts is not very strength

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Efficiency Ratio

3. Stock turnover ratio measures how quickly stock moves through business This ratio means that the average length of time that

the stocks are held before being sold.

= Cost of goods sold

Average stock

It can also be calculated in days

= Average stock x 365 days OR 365 days Cost of goods sold stock turnover

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Efficiency Ratio

4. Asset turnover ratio compares sales to total assets employed Measures how efficient the assets in

generating sales

= Sales x 100%

Average total assets

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SOLVENCY/FINANCIAL LEVERAGE MANAGEMENT RATIO

1. Debt to Equity ratio = Total liabilities

Total Equity

2. Debt ratio

Also call debt to assets ratio

= Total liabilities

Total Asset

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SOLVENCY/FINANCIAL LEVERAGE MANAGEMENT RATIO

- This is to measure the ability of the company to survive over a long period of time

- The ability to pay interest as it come due/mature

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Income Statement for the year ended 31 Dec 2007

Sales 200

Less: Cost of goods sold (100)

Gross profits 100

Less expenses

General 40

Interest 10 (50)

Profit before tax 50

Less: Taxation (15)

Profits after tax 35

Less: Dividends (15)

Retained profits 20

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Balance Sheet as at 31 Dec 2007

Fixed AssetsCurrent Assets Stock Debtors CashCurrent Liabilities Creditors Proposed dividends and taxNet Current assetsTotal assets less current liabilities

Financed by/ capital employed:

Long-term liabilities Loan Preference share capital (50m, $1)

Owners Equity Ordinary Share capital (150m.$1)Other reserves Retained Earning

$ m

604020

(50)(10)

$ m

120

(60)

7050

150

65

$ m275

60335

120

215335

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1. Profitability Ratiosa. Return on Capital Employed Profit after tax = 35 = 16.3% Average capital employed 215

b. Gross Profit RatioGross profit = 100 = 50% Sales 200

c. Net Profit RatioNet profit after taxation = 35 = 17.5% sales 200

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2. Liquidity Ratiosa. Current Ratio

Current assets = 120 = 2:1

Current liabilities 60

b. Quick Ratio

Current assets - stock = 120-60 = 1:1

Current liabilities 60

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3. Efficiency Ratios

Debtors Collection Period

Average debtors x 365 = 40 x 365 = 73 days

Credit sales 200

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c. Stock TurnoverCOGS = 100 = 1.66 times

Average stock 60

d. Asset Turnover Ratio Sales x 100% = 200 x 100%Average total assets 395

= 51%

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4. Financing ratio

a) Debt to equity ratio Total liabilities = 180 = 0.837

Total equity 215

b) Debt ratio

Total liabilities = 180 = 0.456

Total assets 395

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Limitations of the Accounting Information1. Estimates

The financial statement contains numerous estimates. Eg. Provision for doubtful debt, depreciation and contingent loss.

2. CostThe traditional financial statements are based on historical cost, it is not adjusted for price-level change. Eg. Inflation affects the sales growth.

3. Alternative Accounting MethodA comparison may be misleading as different companies use different accounting method. Eg. FIFO and LIFO.

4. Diversification of firmsThis diversification of activities of companies limit the usefulness of financial analysis. (no specific industry).

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CONCLUSION

Ratio analysis is a good way to overview an organisation’s activities

Ratio analysis must be compared with past result or industry norms, not in isolation

Things to be taken into account in using ratio analysis: size of the organisation Method used in accounting treatment Same industry Same country

topic 10 financial statement analysis

Business

total liabilities

income statement

total assets

net income

income taxes1

liabilitiescurrent liabilities

financial statement

deferred income taxes