Financial Analysis

When you are analyzing a financial statement, it is best to reduce amount comparisons to percentages or ratios so that you have an easy way to judge those comparisons. And if you compare those ratio results with what you know to be good, fair Importance or necessary of financial statement : The information given in the financial statement is very useful to a number of parties. These are the followings: 1. Owners: The owners provide fund for the operation of a business and they want to know whether their funds are beings properly utilized or not. 2. Creditors: Creditors want to know the financial position of business concern before giving loans or granting credits. The financial statements help them in judging such position. 3. Investors: Prospective inspectors who want to invest money in firm would like to make an analysis of financial statements of them firm to know how sale the propose investment will be. 4. Employee: Employee are interested are in the financial position of a business concern they serve particularly when the payment of bonus depends upon the profit earned. 5. Government: Center and state government are interested in the financial statement because they reflect the earning for particular period for this period. 6. Consumers: Consumers are interested in the establishment of good accounting contour so that the cost of production may be reduced with the resultant reduction of the price of goods they buy. Limitations a. b. c. d. e. f. g. of financial statement: Internal and not final report. Lack of pricing and definiteness. Lack of objective judgment. Historical nature. Artificial view. Scope of manipulation. Inadequate information.

Ratios to Determine Strength & Weaknesses Everyone in the business of analyzing financial statements has a few favorite ratios they utilize when determining the strengths or weaknesses of a specific financial statement. The ratios that are used could change depending upon the industry the business is in, the size of the business, the accounting the accounting method that is used by the business and the amount of the credit desired and how healthy the company is. Ratio Types of Ratios Liquidity Ratios Asset management/Activity ratios Financial Leverage/Gearing ratios Profitability ratios Market valuation ratios Ratio limitations

A ratio: Is the mathematical relationship between two quantities in the form of a fraction or percentage. Ratio analysis: is essentially concerned with the calculation of relationships which after proper identification and interpretation may provide information about the operations and state of affairs of a business enterprise. The analysis is used to provide indicators of past performance in terms of critical success factors of a business. This assistance in decision-making reduces reliance on guesswork and intuition and establishes a basis for sound judgment. Consider a current ratio of 2:1. This means that for every 1 monetary value of current liabilities there are 2 of assets. However each business is different and each has different working capital requirements. From this ratio, we cannot make any comments about the liquidity of the business, whether it carries too much or too little working capital. Significance of Using Ratios

The significance of a ratio can only truly be appreciated when: 1. It is compared with other ratios in the same set of financial statements. 2. It is compared with the same ratio in previous financial statements (trend analysis). 3. It is compared with a standard of performance (industry average). Such a standard may be either the ratio which represents the typical performance of the trade or industry, or the ratio which represents the target set by management as desirable for the business. Types of Ratios

Note that throughout this section, ratios are derived from Exhibit one in Session 1 of this chapter A: Liquidity Ratios Liquidity refers to the ability of a firm to meet its short-term financial obligations when and as they fall due. The main concern of liquidity ratio is to measure the ability of the firms to meet their short-term maturing obligations. Failure to do this will result in the total failure of the business, as it would be forced into liquidation.

Current Ratio

The Current Ratio expresses the relationship between the firms current assets and its current liabilities. Current assets normally includes cash, marketable securities, accounts receivable and inventories. Current liabilities consist of accounts payable, short term notes payable, short-term loans, current maturities of long term debt, accrued income taxes and other accrued expenses (wages).

The rule of thumb says that the current ratio should be at least 2, that is the current assets should meet current liabilities at least twice. What does the calculated ratio tells us? In 2000, the company only had 85 cents worth of current assets for every dollar of liabilities. This grew to 92 cents in 2002 indicating increasing trend on liquidity, however the company is still unable to support its short-term debt from its currents assets. Quick Ratio: Measures assets that are quickly converted into cash and they are compared with current liabilities. This ratio realizes that some of current assets are not easily convertible to cash e.g. inventories. The quick ratio, also referred to as acid test ratio, examines the ability of the business to cover its short-term obligations from its quick assets only (i.e. it ignores stock). The quick ratio is calculated as follows Clearly this ratio will be lower than the current ratio, but the difference between the two (the gap) will indicate the extent to which current assets consist of stock. Average Collection Period

The average collection period measures the quality of debtors since it indicates the speed of their collection. The shorter the average collection period, the better the quality of debtors, as a short collection period implies the prompt payment by debtors. The average collection period should be compared against the firms credit terms and policy to judge its credit and collection efficiency. An excessively long collection period implies a very liberal and inefficient credit and collection performance. The delay in collection of cash impairs the firms liquidity. On the other hand, too low a collection period is not necessarily favourable, rather it may indicate a very restrictive credit and collection policy which may curtail sales and hence adversely affect profit.

Inventory Turnover

This ratio measures the stock in relation to turnover in order to determine how often the stock turns over in the business. It indicates the efficiency of the firm in selling its product. It is calculated by dividing he cost of goods sold by the average inventory.

The ratio shows a relatively high stock turnover which would seem to suggest that the business deals in fast moving consumer goods. The company turned over stock every 24 days in 2000 and every 28 days in 2002.

The trend shows a marginal increase in days which indicates a slow down of stock turnover. The high stock turnover ratio would also tend to indicate that there was little chance of the firm holding damaged or obsolete stock. Total Assets Turnover

Asset turnover is the relationship between sales and assets The firm should manage its assets efficiently to maximise sales. The total asset turnover indicates the efficiency with which the firm uses all its assets to generate sales. It is calculated by dividing the firms sales by its total assets.

Generally, the higher the firms total asset turnover, the more efficiently its assets have been utilised.

Fixed Asset Turnover

The fixed assets turnover ratio measures the efficiency with which the firm has been using its fixed assets to generate sales. It is calculated by dividing the firms sales by its net fixed assets as follows:

Generally, high fixed assets turnovers are preferred since they indicate a better efficiency in fixed assets utilisation.

From the above calculations: It appears that the activity of the business is relatively constant, with a slight upward trend. The ratio also confirms that the business places a much greater reliance on working capital than it does on the fixed assets as the fixed assets (2001 and 2002) turned over more quicker than stock turnover.

C: Financial Leverage (Gearing) Ratios The ratios indicate the degree to which the activities of a firm are supported by creditors funds as opposed to owners. The relationship of owners equity to borrowed funds is an important indicator of financial strength. The debt requires fixed interest payments and repayment of the loan and legal action can be taken if any amounts due are not paid at the appointed time. A relatively high proportion of funds contributed by the owners indicates a cushion (surplus) which shields creditors against possible losses from default in payment. Note: The greater the proportion of equity funds, the greater the degree of financial strength. Financial leverage will be to the advantage of the ordinary shareholders as long as the rate of earnings on capital employed is greater than the rate payable on borrowed funds. The following ratios can be used to identify the financial strength and risk of the business.

Equity Ratio

The equity ratio is calculated as follows:

This indicates that only 32.1% of the total assets in 2002 is supplied by the ordinary stockholders and this has shown a slight decrease from 32.8% in 2000. A high equity ratio reflects a strong financial structure of the company. A relatively low equity ratio reflects a more speculative situation because of the effect of high leverage and the greater possibility of financial difficulty arising from excessive debt burden.

Debt Ratio This is the measure of financial strength that reflects the proportion of capital which has been funded by debt, including preference shares. This ratio is calculated as follows:

With higher debt ratio (low equity ratio), a very small cushion has developed thus not giving creditors the security they require. The company would therefore find it relatively difficult to raise additional financial support from external sources if it wished to take that route. The higher the debt ratio the more difficult it becomes for the firm to raise debt.

Debt to Equity ratio

This ratio indicates the extent to which debt is covered by shareholders funds. It reflects the relative position of the equity holders and the lenders and indicates the companys policy on the mix of capital funds. The debt to equity ratio is calculated as follows:

The debt to equity ratio shows that for every 1 dollar of shareholders funds in 2002 there was 2.12 dollars of debt. This compares to 2.05 dollars in 2000. This ratio is extremely high and indicates the financial weakness of the business.

Times Interest Earned Ratio

This ratio measure the extent to which earnings can decline without causing financial losses to the firm and creating an inability to meet the interest cost. The times interest earned shows how many times the business can pay its interest bills from profit earned. Present and prospective loan creditors such as bondholders, are vitally interested to know how adequate the interest payments on their loans are covered by the earnings available for such payments. Owners, managers and directors are also interested in the ability of the business to service the fixed interest charges on outstanding debt.

The ratio is calculated as follows:

The companys major forms of credit are non-interest bearing (trade creditors) which results in the business enjoying very healthy interest coverage rates. In 2002 the company could pay their interest bill 16.5 times from earnings before interest and tax. However this is a massive drop from 51.5 times in 2001 and 37.7 times in 2000.

D: Profitability Ratios

Profitability is the ability of a business to earn profit over a period of time. Although the profit figure is the starting point for any calculation of cash flow, as already pointed out, profitable companies can still fail for a lack of cash. Note: Without profit, there is no cash and therefore profitability must be seen as a critical success factors. A company should earn profits to survive and grow over a long period of time. Profits are essential, but it would be wrong to assume that every action initiated by management of a company should be aimed at maximizing profits, irrespective of social consequences.

The ratios examined previously have tendered to measure management efficiency and risk.

Profitability is a result of a larger number of policies and decisions. The profitability ratios show the combined effects of liquidity, asset management (activity) and debt management (gearing) on operating results. The overall measure of success of a business is the profitability which results from the effective use of its resources. Gross Profit Margin Normally the gross profit has to rise proportionately with sales. It can also be useful to compare the gross profit margin across similar businesses although there will often be good reasons for any disparity.

The ratio above shows the increasing trend in the gross profit since the ratio has improved from 15.2% in 2000 to 20.3% on 2002. This indicates that the rate in increase in cost of goods sold are less than rate of increase in sales, hence the increased efficiency.

Net Profit Margin

This is a widely used measure of performance and is comparable across companies in similar industries. The fact that a business works on a very low margin need not cause alarm because there are some sectors in the industry that work on a basis of high turnover and low margins, for examples supermarkets and motorcar dealers. What is more important in any trend is the margin and whether it compares well with similar businesses.

The net margin ratio shows that the margin is fairly stable over time with slight improvement to 1.73% in 2001. However, to know how well the firm is performing one has to compare this ratio with the industry average or a firm dealing in a similar business. Return on Investment (ROI)

Income is earned by using the assets of a business productively. The more efficient the production, the more profitable the business. The rate of return on total assets indicates the degree of efficiency with which management has used the assets of the enterprise during an accounting period. This is an important ratio for all readers of financial statements.

Investors have placed funds with the managers of the business. The managers used the funds to purchase assets which will be used to generate returns. If the return is not better than the investors can achieve elsewhere, they will instruct the managers to sell the assets and they will invest elsewhere. The managers lose their jobs and the business liquidates.

The ratio indicates that there is increase in the ROI from 8.38% in 2000 to 8.95% in 2002. Return on Equity (ROE)

This ratio shows the profit attributable to the amount invested by the owners of the business. It also shows potential investors into the business what they might hope to receive as a return. The stockholders equity includes share capital, share premium, distributable and non-distributable reserves. The ratio is calculated as follows:

Again, the profitability to ordinary shareholders is strong and showing an upward trend. Note that the return in 2002 as in all the years is after tax and the shareholders should be extremely comfortable with these returns. Earning Per Share (EPS)

Whatever income remains in the business after all prior claims, other than owners claims (i.e. ordinary dividends) have been paid, will belong to the ordinary shareholders who can then make a decision as to how much of this income they wish to remove from the business in the form of a dividend, and how much they wish to retain in the business. The shareholders are particularly interested in knowing how much has been earned during the financial year on each of the shares held by them. For this reason, an earning per share figure must be calculated Clearly then, the earning per share calculation will be:

E: Market Value Ratios

These ratios indicate the relationship of the firms share price to dividends and earnings. Note that when we refer to the share price, we are talking about the Market value and not the Nominal value as indicated by the par value. For this reason, it is difficult to perform these ratios on unlisted companies as the market price for their shares is not freely available. One would first have to value the shares of the business before calculating the ratios. Market value ratios are strong indicators of what investors think of the firms past performance and future prospects. Dividend Yield Ratio

The dividend yield ratio indicates the return that investors are obtaining on their investment in the form of dividends. This yield is usually fairly low as the investors are also receiving capital growth on their investment in the form of an increased share price. It is interesting to note that there is strong correlation between dividend yields and market prices. Invariably, the higher the dividend, the higher the market value of the share. The dividend yield ratio compares the dividend per share against the price of the share and is calculated as:

Notice a healthy increase in the yield from 2000 to 2002. The main reason for this is that the dividend per share increased while at the same time, the price of a share dropped. This is fairly unusual because share prices usually increase when dividends increase. However there could be number of reasons why this has happened, either due to the economy or to mismanagement, leading to a loss of faith in the stock market or in this particular stock. Normally a very high dividend yield signals potential financial difficulties and possible dividend payout cut. The dividend per share is merely the total dividend divided by the number of shares issued. The price per share is the market price of the share at the end of the financial year. Price/Earning Ratio (P/E ratio)

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P/E ratio is a useful indicator of what premium or discount investors are prepared to pay or receive for the investment. The higher the price in relation to earnings, the higher the P/E ratio which indicates the higher the premium an investor is prepared to pay for the share. This occurs because the investor is extremely confident of the potential growth and earnings of the share.

The price-earning ratio is calculated as follows:

1. High P/E generally reflects lower risk and/or higher growth prospects for earnings. 2. The above ratio shows that the shares were traded at a much higher premium in 2000 than were in 2002. In 2000 the price was 26.8 times higher than earnings while in 2002, the price was only 12 times higher. Dividend Cover This ratio measures the extent of earnings that are being paid out in the form of dividends, i.e. how many times the dividends paid are covered by earnings (similar to times interest earned ratio discussed above). A higher cover would indicate that a larger percentage of earnings are being retained and re-invested in the business while a lower dividend cover would indicate the converse.

Dividend pay-out ratio

This ratio looks at the dividend payment in relation to net income and can be calculated as follows:

Note: Even though the dividend yield has increased, the dividend payout ratio has reduced, showing that a lower proportion of earnings was paid out as dividend. The ratio has only reduced slightly, however, from 50.7% in 2000 to 49.4% in 2002.

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Generally, the low growth companies have higher dividends payouts and high growth companies have lower dividend payouts. Relationship Among Ratios Summary of Financial Ratios & Their Meaning 1. Profitability Ratios

Ratios a. Contribution Margin to sales

Formula Contribution Margin *1000 / Sales

Meaning Measures the margin of profitability on sales throughout the trading year and will vary from industry to industry. The percentage should be relatively constant and any changes investigated. Reasons for changes could be reduced selling price or increase in the cost of sales. The % of COGS relative to sales. Helps measure the relative costs of inputs. The % if any operating expenses relative to sales. Measures the relative impact of operating expenses. % of net income earned for every sales Taka. Measures ultimate profitability.

Desired Trend The higher the ratio the higher the cut received on each sales

b. COGS sales

to

COGS Sales

x1000/

Net

The lower the ratio, the lower the costs.

c. Operating expenses to sales

Operating Expenses x100/ Net sales

The lower the ratio, the lower the expense relative to sales. The higher the ratio, the more profitable each sale.

d. Net income to sales

Net income x 100/ Net Sales

2. Return on Investment: Ratio a. Return on Assets (ROA). b. Return on Equity (ROE) Formula Net Income/ Average Total Assets ( May also use EBIT instead of net income) Net Income/ Average Shareholders Equity Meaning Shows the relationships between income & total assets. Shows the maximum return available to shareholders. Desired Trend High return = Good use of assets. High return = Happy shareholders/owners .

3. Investment / Assets Utilization Ratio Formula Asset Turnover Net Sales / Net Assets

Meaning Shows how fully the company is using its capital and how many

Desired Trend Higher is better; Too low- useless assets but

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Inventory Turnover

COGS / Inventory

Average

pounds of turnover is generated by each pound of investment. Helps measure the usefulness of the assets. How many times a year is the inventory being sold? Measures the speed at which the inventory comes in & goes out. Or, Measures liquidity of inventory. How many sales dollars are earned for every dollar of fixed assets? Helps measure how useful the fixed assets are to the business.

Too high-perhaps not enough assets may be forgoing opportunities. Higher is better; Too low- the inventory is sitting around to long. (Obsolescence) but Too high-may not have enough inventory to meet demand (stock outs) Higher is better; Too low- may have useless assets that can be sold. but Too high-may sign that are old & need replacing.

Fixed Assets Turnover

Net Sales / Average Net Fixed Assets

4. Liquidity Ratio: Ratios Formula a.Current Ratio Current Assets / Current Liabilities

Meaning The number of times that short-term assets can cover short-term debts. It indicates an ability to meet short term obligations as they come due. Indicates the ability to meet short term payments, using only the most liquid of assets. The net amount of money tied up in working capital. How old (in days) is the average outstanding balance on credit sales.

Liquidity Ratio or Acid Test

Current Assets minus Stock / Current Liabilities

Desired Trend Higher to a point (2:1 rule of thumb) Too low-may lead to insolvency but too high-inefficient use of capital ( since current assets generally have the lowest return) Higher to a point (1:1 rule of thumb)

Working Capital

Current Assets - Current Liabilities.

Age Receivable Or Average Collection Period.

of

Account Receivable/ Average daily sales. Average Daily sales = Total Sales/365

Higher is safer but working capital has a low return; if too high, moneys better spent elsewhere. Should be closed to the industry average (Preferably on the lower end) If too low- may be the credit policies are too tight & are scaring off business. Desired trend Lower is safer

5. Solvency Ratios/ Stability Ratios Ratios Formula a. Total Debt to Total liabilities/ Total

Meaning What percentage

of

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total assets ratio

Equity

b. Debt Equity

to

Total Assets

liabilities/

Total

the business is financed through debt. Or Measures the % of the total assets provided by creditors. The number of times of debt for every dollar of equity.

c. Net worth to Total Assets

Total Equity/ Total Assets

What percentage of the business is owned by equity?

d. Time interest earned or Long-term Debt interest Coverage

EBIT/ Interest term debt.

on

long

The number of times over that a company can meet its interest payments.

Lower is safer. To high-to highly leveraged(either too much debt or too small an equity base.) Higher is safer. Too low- too much debt but Too high likely under leveraged thereby reducing ROE. Also debt is cheaper than equity, use it if possible. Lenders need assurance that their loan charges (interest) can be covered.

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