Principles of Financial
Analysis
Week 2: Lecture 2
Lecturer: Chara Charalambous
1
Learning Goals
• Accounting
focuses on how financial
statements are made, Managerial Finance
focuses on how financial statements are used
by the management to improve the firm’s
performance and by investors to examine the
firm’s financial position when evaluating its
attractiveness as an investment.
Lecturer: Chara Charalambous
2
Analysis of financial statements:
A Managerial view
• Financial statement analysis involves a comparison
of a firm’s performance with that of other firms
operating in the same industry. Generally the
analysis is used to determine the firm’s financial /
economic position in order to identify its current
strengths and weaknesses and to suggest actions
the firm might perform to take advantage of the
strengths and correct the weaknesses in the future
Lecturer: Chara Charalambous
3
Who analyzes financial statements?
Financial statement analysis is not only important for the firm’s
managers
– Internal users (i.e., management)
– External users
• Examples?
•
Investors, creditors & …
•
stock market analysts and
•
auditors
Lecturer: Chara Charalambous
4
• What do internal users use it for?
Planning, evaluating and controlling company
operations. Also analysis help to make financing and
investment decisions to maximize the firm’s value.
• What do external users use it for?
Assessing past performance and current financial
position and making predictions about the future
profitability and the ability of the company to meet its
current and expected future economic obligations. As
well as evaluating the effectiveness of management.
in this way they see how attractive is the firm
as an investment
Lecturer: Chara Charalambous
5
Financial Statement Analysis
Information is available from
– Published annual reports
•
•
•
•
•
(1)
(2)
(3)
(4)
(5)
Financial statements
Notes to financial statements
Letters to stockholders
Auditor’s report (Independent accountants)
Management’s discussion and analysis
– Reports filed with the government
– Other sources
• (1) Newspapers
• (2) Periodicals
• (3) Financial information organizations such
as: Moody’s, Standard & Poor’s e.t.c
• (4) Other business Lecturer:
publications
Chara Charalambous
6
Annual Report
• A report used annually (yearly) by a
corporation to its stockholders. It contains
basic financial statements (the income
statement, the balance sheet and the
statement of cash flows) as well as
management’s opinion of the past years
operations and the firm’s future prediction.
Together these statements give an accounting picture of the
firm’s operations and financial position . Detailed data are
provided for the two most recent years.
Lecturer: Chara Charalambous
7
The Income Statement
Trading and Profit and Loss statement
• Contains information on the profitability of
the firm during some period of time
• Indicates the firm’s revenues - sales, expenses,
and earnings during an accounting period.
THE NET INCOME AVAILABLE TO STOCKHOLDERS
o Recall from what you learned in accounting that the income statement is
created using the accrual method of accounting: revenues are recognized
when they are earned not when the cash is received, and expenses are
realized when they are incurred, not when the cash is paid.
Lecturer: Chara Charalambous
8
Comparative Income Statement for years ending 31st Dec
(millions of Euros except the per share data)
Net Sales
Cost of Goods Sold
Gross Profit
Fixed operating expenses
Depreciation
Earnings before interest and taxes (EBIT)
Interest
Earnings before Taxes (EBT)
Taxes (40%)
Net Income
Dividends of preference shares
Earnings available to common stockholders (EAC)
Common Dividends
Addition to retain earnings
Per Share data(25,000,000 shares):
Shares issued (quantities)
Common stock price
Earnings per share
Lecturer: Chara Charalambous
Dividends per share
2000
1500
(1230)
270
(90)
(50)
130
(40)
90
(36)
54
0
54
(29)
25
25
€23
€2.16
€1.16
1999
1435
(1176.7)
258.3
(85)
(40)
133.3
(35)
98.3
(39.3)
59
0
59
(27)
32
25
€23
€2.36
9
€1.08
Evaluating a Firm’s EPS
 We can use the income statement to determine the earnings per share
(EPS) and dividends.
 EPS = Net income/Number of shares outstanding
 Example 1: A firm reports a net income €54 million and has 25 million
shares outstanding, what will be the earnings per share (EPS)?
 EPS = Net income ÷ Number of shares
= €54 million ÷ €25 million
= €2.16
•
•
•
•
Book value per share = (Common equity)/Shares €16.60
Market value per share (stock price) €23.00
Earnings per share = (Net income)/Shares €2.16
Dividends per share = (Common dividends)/Shares = 29/25=
€1.16
Lecturer: Chara Charalambous
10
The Balance Sheet
• Shows the financial position of a firm at a
specific point in time. This statement shows
the investments made by the firm in the form
of assets and the means by which the asset
were financed: by borrowing (liabilities) or by
selling ownership shares (equity).
The retained earnings account is built up over time as the firm ‘saves’ a
part of its earnings rather than paying out as dividends. The accounts
common stock and paid-in capital regards the funds came from selling
stock and the amount of money the owner put up respectively.
Lecturer: Chara Charalambous
11
Comparative Balance sheets as at 31 Dec (millions of Euros)
Fixed Assets
Plant and Equipment
Less: Accumulated Depreciation
Current Assets
Inventory
Debtors
Cash
Total Assets
Equity and Liabilities
Owner’s equity
Paid – in Capital
Common stock (25,000,000 shares)
Retained Earnings
Long Term Loans
Current Liabilities
Creditors
Accruals
Total Equity and Liabilities
2000
680
(300)
270
180
15
380
465
845
1999
600
(250)
200
160
40
350
400
750
0
130
285
415
300
0
130
260
390
255
30
100
845
15
90
750
Lecturer: Chara Charalambous
12
Account of Retained Earnings for the Period
Ending December 31, 2000 (€ million)
Balance of retained earnings, December 31, 2008
Add: 2000 net income
$260.0
54.0
Less: 2000 dividends paid to stockholders
(29.0)
Balance of retained earnings, December 31, 2009
$285.0
13
Statement of Cash Flow
Cash flow statement – How did the cash come and go?
cash received and cash spent by the firm over a period
of time.
• Designed to show how the firm’s operations have
affected its cash position
• Examines investment decisions
(uses of cash)
• Examines financing decisions
(sources of cash)
Lecturer: Chara Charalambous
14
Ratio Analysis
•
Ratio analysis is used to evaluate relationships
between items in the financial statements. The
ratios are used to identify trends over time for one
company or to compare two or more companies at
one point in time. Financial statement ratio analysis
focuses on three key aspects of a business: liquidity,
profitability, and solvency (debt management
ratios).
15
The Purpose of Ratio Analysis
• Gives an idea of how well the company
is doing
• Homogenize
numbers;
facilitates
comparisons
• Used to highlight weaknesses and strengths
16
Liquidity ratios
Liquidity ratios measure the ability of a company to repay its
short-term debts and meet unexpected cash needs.
1.
Current ratio. The current ratio is also called the working
capital ratio, as working capital is the difference between
current assets and current liabilities. This ratio measures the
ability of a company to pay its current obligations using current
assets. The current ratio is calculated by dividing current assets
by current liabilities.
Current Ratio =
=
Current Assets
Current Liabilities
€465.0
€130.0
=
Weak
liquidity
position
compared to this
of the industry
3.6 times
Industry average
e.g.4.1 times
Lecturer: Chara=
Charalambous
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• A company needs adequate current assets to
meet current debts, to carry enough
inventories, and to take advantage of cash
discounts.
• A company that has low current ratio is less
able to meet current obligations or to continue
operating.
• A high current ratio suggests a strong liquidity
position and an ability to meet current
obligations.
Lecturer: Chara Charalambous
18
2. The quick or acid test ratio is calculated by deducting stock from current
assets and then dividing the amount by current liabilities. Stock is
typically the least liquid of a firm’s current assets. Hence it is the asset on
which losses are the most probably to occur in the event of liquidation.
Therefore the ability of a company to pay short-term obligations without
relying on the sale of stock is important.
Quick Ratio = Current Assets- Inventories
Current Liabilities
195.0 = 1.5 times
465.0
270.0
=
=
130.0
130.0
Industry average = 2.1 times
Low quick ratio compared to these of other
companies in the industry. But still if the
debtors pay their debts to the firm , the
company can pay its current liabilities even if it
doesn’t liquid its stock.
Lecturer: Chara Charalambous
19
• Acid – test ratio assess whether a Company
has enough liquid assets to meet its current
liabilities.
Lecturer: Chara Charalambous
20
Profitability Ratios
• Profitability refers to a company’s ability to
generate satisfactory return on invested
capital.
• Return is judged by assessing earnings relative
to the level and sources of financing.
• Profitability is also relevant to solvency.
Lecturer: Chara Charalambous
21
Profitability Ratios
1. Net Profit Margin : gives the profit per euro of sales
Net income
Profit margin =
Sales
=
54.0
= 0.036 = 3.6%
1,500
Industry Average =
4.9%
Net income is calculated by deducting
from sales all expenses and costs:
regarding this company Its sales are too
low or its costs are too high or both.
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2. Return on Total Assets: ROA the ratio of net income
to total assets provides an idea of the general return
on investment earned by the firm.
Net income
ROA =
Total assets
=
54.0
845.0
= 0.064 = 6.4%
Industry Average = 12.3%
The investments done in assets didn’t give high return
because the net profit is low, this means that the company
has high loans which makes it pay high interests.
Lecturer: Chara Charalambous
23
3. Return on Common Equity: ROE this ratio measures
the rate of return on stockholders investment.
Measures how much net income was earned relative
to each euro of common stockholders' equity.
Net income
ROE =
Owner’s equity
= 54.0 - 0 = 0.130 = 13.0%
415.0
Industry Average = 17.7%
The investment of the stockholders give lower return
compared to this of the industry.
Lecturer: Chara Charalambous
24
Solvency – Debt Management Ratios
• Solvency refers to a company’s long financial
capability and its ability to cover long – term
obligations.
• All of a company’s business activities –
financing, investing, and operating – affect its
solvency.
Lecturer: Chara Charalambous
25
Solvency – Debt Management Ratios
1. Debt Ratio: measures the percentage of the firm’s
assets financed by debt – borrowing.
Debt Ratio = Total liabilities = short + long term
Total assets
current + fixed
130+300 = 430.0
845
845.0
= 0.509 = 50.9%
Industry Average = 42.0%
The debt is higher than the value of assets. This it will
make it difficult to borrow additional funds and also there
is greater danger of bankruptcy
Lecturer: Chara Charalambous
26
2. Times Interest Earned : measures the extent to which
earnings before interest and taxes can cover interest
charges. Failure to cover this obligation can bring legal
action by the firm’s creditors, possibly resulting in
bankruptcy.
TIE =
EBIT (Earnings before interest and taxes)
Interest charges
$130.0
= 3.3 times
=
$40.0
Industry Average =
6.5 times
This company is covering its interest charges by a low
margin of safety. In the future it will face difficulties if it
attempts to borrow additional funds.
Lecturer: Chara Charalambous
27
QUESTIONS
Lecturer: Chara Charalambous
28
APPENDIX - Types of share capital
• Authorised share capital is also referred to as
registered capital. It is the total of the share capital
which a limited company is allowed (authorised) to
issue.
– Shares authorised = Shares issued + Shares unissued
• Issued share capital is the total of the share capital
actually issued to shareholders. This may be less or
equal to the authorised capital.
• Called up share capital is the total amount of
issued capital for which the shareholders are
required to pay.
• Paid up share capital is the amount of share capital
paid by the shareholders. This may be less than the
called up capital as payments may be in instalments
("calls-in-arrears").
Chara Charalambous CDA COLLEGE
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