Financial Statement Analysis:
Major Areas:
•Liquidity
•Profitability
•Debt level
•Efficiency
•Market status
When using ratios to analyze the financial statements of a
company it is usual to consider a number of themes:
1: LIQUIDITY:
Is the company able to pay its immediate debts, or is it going
to run out of cash?
2: PROFITABILITY:
How well has the company performed in terms of profit and
the resources used to earn that profit?
3: DEBT:
Does the company have so much debt that it is high risk?
4: EFFICIENCY:
How well has the company used its assets to generate sales?
5: MARKET RELATED:
What are the earnings and dividends?
Liquidity Analysis:
Is the company able to pay its immediate debts, or is it going
to run out of cash?
Current ratio:
Current assets/current liabilities:
2000
$1,528/$1,125 = 1.36:1
1999
$1,902/$1,441 = 0.96:1
The ratio has increased, but is still below the 2:1 we expect.
Quick ratio:
(Current assets – inventories)/current liabilities
($1,528 - $412)/$1,125 = 0.99:1 ($1,902 - $473)/$1,441 = 0.99:1
The ratio is constant and acceptably close to 1:1.
2: PROFITABILITY: How well has the company performed in
terms of profit and the resources used to earn that profit?
Return on sales %:
Operating income/sales *100:
$335/$5,207 * 100 = 6.4%
$324/$4,728 * 100 = 6.9%
A low margin business, and declining!
Return on assets %:
Operating income/total assets * 100:
$335/$3,748 * 100 = 8.9%
$324/$3,871 * 100 = 8.4%
A modest return, but increasing.
Return on equity %:
Net income/shareholders’ equity * 100:
$148/$1,460 * 100 = 10.1%
$146/$1,345 * 100 = 10.9%
A modest return, and declining!
3: DEBT:
Does the company have so much debt that it is high risk?
Debt to assets %:
Total debt/total assets * 100:
$2,288/$3,748 *100 = 61%
$2,526/$3,871 * 100 = 65%
More than 50% of assets are financed by debt: high risk.
Debt to equity %:
Total debt/shareholders’ equity * 100:
$2,288/$1,460 * 100 = 157%
$2,2\526/$1,345 * 100 = 188%
Debt is more than 100% of equity: high risk.
Interest cover ratio:
Net income after tax, but before interest/interest expense:
($148 + $95)/$95 = 2.6 times
($146 + $97)/$97 = 2.5 times
Interest expense is adequately covered by net income.
4: EFFICIENCY:
How well has the company used its assets to generate sales?
Total asset turnover:
Sales/total assets:
$5,207/$3,748 = 1.39 times
$4,728/$3,871 = 1.22 times
Slightly more efficient in year 2000.
The company can work on its efficiency in two ways:
1: By increasing the sales from the existing level of assets.
This means earning their profit margin on sales more
frequently.
2: By reducing the assets used to generate the same level of
sales. This means an increase in their return on assets %.
Opportunities to manage individual assets are shown in the
receivables and inventory ratios that follow.
Receivables turnover ratio:
Credit sales/receivables:
$5,207/$969 = 5.4 times
$4,728/$873 = 5.4 times
OR:
Receivables collection period:
Receivables/(credit sales/365):
$969/($5,207/365) = 67.9 days $873/($4,728/365) = 67.4 days
Receivables are being “turned over” 5.4 times per year, which
is equivalent to collection receivables in 67 days on average.
Bear in mind that these financial statements are for Canadian
Tire the wholesalers, not the retail outlets. Retail branches of
Canadian Tire would have much lower receivables collection
periods.
Inventory turnover ratio:
Cost of goods sold/inventory:
$<5,207/$412 = 12.6 times
times
$<4,728/$473 = 10
OR
Inventory holding period:
Inventory/(cost of goods sold/365):
$412/(<$5,207/365) = 29 days $473/$(<4,728/365) = 39 days
The company has become much more efficient in respect of
inventory. It is now turned over 12.6 times per year, (i.e. held
for less than one month). As long as this did not lead to
reduced sales (through being “out of stock”) it represents
good management.
Market related ratios:
Earnings per share:
Net income/number of common shares:
$148/79 = $1.87
$146/78 = $1.87
Investors make buy/sell decisions partly on the basis of
how many $ of earnings each share is entitled to. This has
not changed.
Dividend cover ratio:
Net income/dividend:
$148/$31 = 4.8 times
$146/$31 = 4.7 times
Dividend payout %:
Dividend/net income * 100:
$31/$148 * 100 = 20.9%
$31/$146 * 100 = 21.2%
Investors are also interested in what % of the earnings is
paid out as dividends, and what % is ploughed back into
the company. This was around 21% payout in both years.
Summary:
Canadian Tire is a solid, but unexciting company from this
analysis of its financial results for 1999 and 2000.
It is low liquidity, but not dangerously so;
It has rather too much debt for comfort;
It has modest returns on its assets and sales;
Efficiency is somewhat improved in 2000 over 2001, mainly
due to better management of inventory;
It ploughs back almost 80% of earnings into growth
through new investment.
Chapter Problem
Canadian Tire further example – 2001
Adds one more year for the same company
Canadian Tire: Consolidated Statement of Earnings and Retained Income:
$ million, for the Year:
2001
Gross operating revenue
5,374
Less: Cost of goods sold & operating expenses:
Various
Depreciation
4,874
136
5,010
Operating income
Less:
Interest
Taxes
364
88
100
188
Net income
176
Add: retained earnings at start of year
860
1,036
Less:
Cost of repurchase of shares
32
Dividends paid
31
63
Retained earnings at end of year
973
Canadian Tire: Consolidated Balance Sheet:
$ million, as at the end of:
2001
Current assets:
Cash
579
Accounts receivable
959
Inventory
441
Prepaid expenses
14
Total current assets
1,993
Long-term assets (net)
2,378
Total assets
4,371
Current liabilities
1,110
Long-term liabilities
1,357
Total liabilities
2,467
Minority interest
300
Shareholder’ equity:
Share capital
622
Retained earnings
982
Total shareholders equity
1,604
Total liabilities & shareholders’ equity
4,371
Liquidity
Current ratio:
Definition: Current assets/current liabilities
$1,993/$1,110 = 1.8:1
Reasonable liquidity, close to the norm of 2:1
Quick ratio:
Definition: (Current assets – inventories)/current liabilities
($1,993 - $441)/$1,110 = 1.4:1
Relatively high liquidity, well above the norm of 1:1
Profitability
Return on sales %:
Definition: Operating income/sales * 100
$364/$5,374 * 100 = 6.8%
This is a relatively low margin business, and Canadian Tire is probably
operating at the low end of the range.
Return on assets %:
Definition: Operating income/total assets * 100
$364/$4,371 = 8.3%
A very modest return on assets
Return on equity %:
Definition: Net income/shareholders' equity * 100
$176/$1,604 = 11.0%
This is a modest return for a business investment. Would shareholders have
been better off if they had invested in shares of other companies?
Debt
Debt to Assets %:
Definition: Total debt/total assets * 100
$2,467/$4,371 =56%
Debt to equity %:
Definition: Total debt/total equity * 100
$2,467/$1,904 = 130%
The debt is a little on the high side being over the norm of 50% (debt to assets) or its
equivalent 100% (debt to equity).
The “minority interest” is problematical in this analysis. It refers to shares in subsidiary
companies held by outside investors. It has been treated as equity here to calculate the
debt to equity ratio, but it has been ignored above in the calculation of the return on equity.
Interest cover ratio:
Definition: Net income (after tax, before interest)/interest paid
($176 + $88)/$88 = 3 X
This is safe: earnings would have to fall to one third of their present level before interest
payments were under threat,
Efficiency – Assets and Receivables
Total asset turnover
Definition: sales/total assets
$5,374/$4,371 = 1.2 X
Assets are turned over 1.2 times per year. This is not a capital-intensive business, so this
ratio is relatively low.
Receivables turnover ratio:
Definition: sales/receivables
$5,374/$959 = 5.6 X
Receivables collection period:
Definition: receivables/ (sales/365)
$959/($5,375/365) = 65 days
Receivables are turned over 5.6 times every year, in other words the average age of
receivables is 65 days. In most retailing businesses this would be excessive, but Canadian
Tire credit accounts are much like credit cards, and charge a high interest rate, so it is not a
wasted investment.
Efficiency - Inventory
Inventory turnover:
Definition: sales/inventory
$5,374/$441 = 12,2 X
Inventory holding period:
Definition: inventory/ (sales/365)
$441/($5,374/365) = 30 days
Inventory is turned over 12.2 times per year, in other words
it is held for only 30 days on average. For a retailer of nonperishable goods this is a highly efficient.
Market Ratios
Earnings per share:
Definition: net income/number of common shares
(there were approximately 75 million common shares in
issue)
$176/75 = $2.35
Dividend cover ratio
Definition: net income/dividend
$176/$31 = 5.7 X
This is very safe: there are $5.70 of earnings for every $1 of
dividend