CHAPTER
18
FINANCIAL STATEMENT
ANALYSIS
FINANCIAL STATEMENT ANALYSIS
• Analysing financial statements involves
evaluating three characteristics of a company:
Who needs to know:
1. its liquidity
- short-term creditor
2. its profitability – long-term creditor, investors, shareholders.
3. its solvency
-long-term creditors, investors, shareholders
COMPARATIVE ANALYSIS
• Three types of comparisons:
1. Intracompany basis – focused within company
2. Intercompany basis – focuses on you vs. competition
3. Industry averages - focuses on your industry
1. Intracompany Basis
• Compares an item or account on a financial
statement within the company in a given
year with the same item or relationship in
prior years.
– ie. Cash as a % of total current assets for the
last three years.
• Useful for detecting changes in financial
relationships and significant trends within a
company
2. Intercompany Basis
• Compares an item within the company in a given
year with the same item in one or more
competing companies.
– ie. Walmart’s total sales compared to HBCs total sales
• Useful for understanding a company’s
competitive position
3. Industry Averages
• Compares an item of a company with industry averages
(or norms)
• Averages found in annual publications such as:
– The Financial Post’s Industry Reports
– Statistics Canada
• Financial Performance Indicators for Canadian Business.
• Provides info about a company’s relative performance
within the industry.
COMPARATIVE ANALYSIS
•
Three tools:
1. Horizontal analysis (Trend Analysis)
 Evaluates a series of financial statement data over a period of
years.
 Used primarily in intracompany comparisons
2. Vertical analysis (Common Size Analysis)
 Evaluates financial statement data by expressing each item in a
financial statement as a percentage for the same period of time
 Used in both intracompany and intercompany comparisons.
3. Ratio analysis
 Expresses the relationship among selected items of financial
statement data.
 Used in intracompany, intercompany, and industry average
comparisons.
HORIZONTAL ANALYSIS
 Determines an increase or decrease that has taken place.
 May be expressed as either a $ amount or as a % percentage.
Current year amount — Base year amount
———————————————————————
Base year amount
Change
since base
period
ANY COMPANY INC.
Assumed Net Sales
For the Year Ended December 31 (in millions
2003
$ 6,562
127%
2002
$ 6,295
121%
)
2001
2000
1999
$ 6,190
119%
$ 5,786
112%
$ 5,181
100%
For 2003: 6562.8 / 5181.4 = 1.266 = 127%
VERTICAL ANALYSIS
• Expresses each item in a financial statement as a percent of a base amount
ANY COMPANY, INC.
Condensed Balance Sheets (Partial)
December 31 (in millions)
Assets
Current assets
Capital assets
Other assets
Total assets
2002
Amount
$1,496.5
2,888.8
666.2
$5,051.5
Percent
29.6
57.2
13.2
100.0%
2001
.
Amount
Percent
$1,467.7
30.1
2,733.3
56.9
636.6
13.0
$4,837.6
100.0%
RATIO ANALYSIS
• Liquidity Ratios
– Measure short-term ability of the enterprise to pay its
maturing obligations (current liabilities) and to meet
unexpected needs for cash.
• Profitability Ratios
– Measure the income or operating success of an enterprise for
a given period of time.
• Solvency Ratios
– Measure the ability of the enterprise to survive over a long
period of time.
Ratio Analysis
Can be expressed in 3 ways:
Example:
Current Assets are $33.4 million and Current Liabilities are $13.8 million.
1.
2.
3.
By Percentage:
Current assets are 240% of current liabilities.
By Rate:
Current assets are 2.4 times greater than current
liabilities.
By Proportion:
The relationship of current assets to liabilities is 2.4 : 1
LIQUIDITY RATIOS
•
•
•
•
•
•
•
Current ratio
Acid test ratio
Cash current debt coverage ratio
Receivables turnover
Collection period
Inventory turnover
Days sales in inventory
CURRENT RATIO
Working Capital Ratio
Current Ratio =
Current Assets
Current Liabilities
• Measures short-term debt-paying ability
• Limitations: Portion of CA may be tied up in
uncollectable A/R’s or slow moving inventory.
• Useful when comparing to industry averages
(Discussed in Chapter 4)
ACID TEST (QUICK) RATIO
Acid test ratio =
Cash + temporary investments + net receivables
Current liabilities
•
•
•
•
•
Measures immediate term debt-paying ability
Generally a 1 : 1 is adequate.
Does not include Inventory and Prepaids
Compare it to the industry average.
Limitations: Year end account balances may not
represent position during most of the year.
RECEIVABLES TURNOVER
Receivables turnover =
Net credit sales
Average net receivables
• Measures liquidity of receivables – the number of times
receivables are collected during the fiscal period.
Net Credit Sales = Net Sales – Cash Sales
Net Sales = Total Sales – Sales Returns and Discounts.
Average Net Receivables = Beginning Net Receivables + Ending
Net Receivables
2
(Discussed in Chapter 9)
COLLECTION PERIOD
Collection period =
365 days
Receivables turnover
• Measures number of days receivables are
outstanding. (The number of days it takes to
collect the receivables.)
• Used to assess a company’s credit and
collection policies.
• Collection period should not exceed the credit
term period (net 30).
(Discussed in Chapter 9)
INVENTORY TURNOVER
Inventory turnover =
Cost of goods sold
Average inventory
• Measures liquidity of inventory – the average
number of times the inventory is sold during the
period.
• Average Inventory =
Beginning Inventory + Ending Inventory
2
(Discussed in Chapter 5)
DAYS SALES IN INVENTORY
• Measures number of days inventory is on
hand or average selling time.
Days in inventory =
365 days
Inventory turnover
(Discussed in Chapter 5)
PROFITABILITY RATIOS
 Measure
income or operating success for a specific period
of time
 Profitability impacts company’s ability to obtain debt and
equity financing.
•
•
•
•
•
•
Profit margin
Gross profit margin
Cash return on sales
Asset turnover
Return on assets
Return on common
shareholders’ equity
•
•
•
•
•
•
Book value per share
Cash flow per share
Earnings per share (EPS)
Price-earnings (PE) ratio
Payout ratio
Dividend yield
PROFIT MARGIN
• Measures net income generated by each
dollar of sales
Profit margin =
Net income
Net sales
(Discussed in Chapter 5)
GROSS PROFIT MARGIN
• Indicates a company’s ability to
maintain its selling price above its cost of
goods sold.
Gross profit margin =
Gross profit
Net sales
(Discussed in Chapter 5)
CASH RETURN ON SALES
• Measures net cash flow generated by
each dollar of sales
• Measures profit margin based on cash
basis of accounting. Does not include
sales in A/R.
Cash return on sales =
Net cash provided by operating activities
Net sales
(Discussed in Chapter 18)
ASSET TURNOVER
• Measures how efficiently assets are used
to generate sales  indicates the dollar
of sales produced by each dollar of
assets.
Asset turnover =
Net sales
Average total assets
(Discussed in Chapter 10)
RETURN ON ASSETS
• Measures overall profitability of assets
Return on assets =
Net income
Average total assets
(Discussed in Chapter 10)
RETURN ON COMMON
SHAREHOLDERS’ EQUITY
• Measures profitability of common
shareholders’ investment
Return on common shareholders’ equity =
Net income
Average common shareholders’ equity
Common Shareholder’s Equity =
Total Shareholder’s Equity – Preferred Shares
(Discussed in Chapter 14)
BOOK VALUE PER SHARE
• Measures the equity (net assets) per
common share
Book value per share =
Common shareholders’ equity
Number of common shares
(Discussed in Chapter 14)
CASH FLOW PER SHARE
• Measures the net cash flow per common
share
Cash flow per share =
Net cash provided by all activities
Number of common shares
• Don’t need to know
(Discussed in Chapter 18)
EARNINGS PER SHARE (EPS)
• Measures net income earned on each
common share
• This is only meaningful when used as an
intracompany comparison
Earnings per share =
Net income
Number of common shares issued
(Discussed in Chapter 15)
PRICE-EARNINGS (PE) RATIO
• Measures relationship between market price per
share and earnings per share
• Reflects investors’ assessment of a company’s
future earnings.
• Share sold for “ratio” times the amount that was
earned on each share.
Price-earnings ratio =
Share price
Earnings per share
(Discussed in Chapter 15)
PAYOUT RATIO
• Measures % of earnings distributed in the form
of cash dividends
Payout ratio =
Cash dividends
Net income
• Companies with high growth rate usually have
low payout ratios because they reinvest most of
their net income in the business.
• Companies with stable earnings usually have high
payout ratios.
(Discussed in Chapter 15)
DIVIDEND YIELD
• Measures rate of return earned from
dividends
Dividend yield =
Cash dividends per share
Share price
Cash Dividend Per Share =
Cash Dividend / # of Common Shares
(Discussed in Chapter 15)
SOLVENCY RATIOS
Measures a company’s ability to survive over
a long period of time.
Ability to pay interest on long-term debt and
repay principal when it comes due.
Ratios include:
• Debt to total assets
• Interest coverage
• Cash interest coverage
• Cash total debt coverage
DEBT TO TOTAL ASSETS
• Measures % of total assets provided by
creditors
Debt to total assets =
Total liabilities
Total assets
(Discussed in Chapter 16)
INTEREST COVERAGE
• Measures ability to meet interest payments
as they come due based on accrual
method.
Interest coverage =
Income before interest expense
and income tax expense (EBIT)
Interest expense
• The higher the number the better
(Discussed in Chapter 16)
CASH INTEREST COVERAGE
• Measures cash available to meet interest
payments as they come due (cash basis)
Cash interest coverage =
Income before interest expense, income tax
expense, and amortization expense (EBITDA)
Interest expense
(Discussed in Chapter 16)
CASH TOTAL DEBT COVERAGE
• Measures long-term debt-paying ability (cash
basis) without having to liquidate assets
Cash total debt coverage ratio =
Net cash provided by operating activities
Average total liabilities
• If CTDC was .2 times, then it would mean that
it would take five years (1/.2) to generate
enough cash to pay off all its liabilities.
(Discussed in Chapter 18)