Financial Statement Analysis

Dr. Hermanto, MBA Fakultas Ekonomi Universitas Mataram

Hermanto

Financial Accounting and Business

Karl Marx: Business cannot exist, except in very primitive forms, without accounting. Accounting data makes the business visible, and makes it possible to manage the business and understand it. Accounting makes it possible for the business to work in many locations, directed by a central team.
Hermanto

Uses of Financial Statement

IASC: The objective of financial statement is to provide information about the financial position, performance and changes in financial position of an enterprise that is useful to a wide range of users in making economic decisions.

Hermanto

Annual Report
Typically consists of: Income statement The balance sheet The notes to the accounts The cash flow statement The audit report

Hermanto

Financial Statements
The balance sheet does not, though, purport to show what the company is worth. Financial statements give certain economic information about a companys past activities. Financial statements give partial information.

Hermanto

Important to know in using financial statements:

a) What are the rules b) To what extent are they flexible c) How this impacts upon intepretation of the information

Hermanto

The Company Value

From a market perspective: a) Based on future earnings b) These earnings may well be different in different situations.

Hermanto

Business Survival:
There are two key factors for business survival: Profitability Solvency Profitability is important if the business is to generate revenue (income) in excess of the expenses incurred in operating that business. The solvency of a business is important because it looks at the ability of the business in meeting its financial obligations.
Hermanto

Financial Statement Analysis

Financial Statement Analysis will help business owners and other interested people to analyse the data in financial statements to provide them with better information about such key factors for decision making and ultimate business survival.

Hermanto

Financial Statement Analysis

Purpose: To use financial organisations
Financial performance Financial position.

statements

to

evaluate

an

To have a means of comparative analysis across time in terms of:

Intracompany basis (within the company itself) Intercompany basis (between companies) Industry Averages (against that particular industrys averages)

To apply analytical tools and techniques to financial statements to obtain useful information to aid decision making.
Hermanto

Financial Statement Analysis

Financial statement analysis involves analysing the information provided in the financial statements to:
Provide information about the organisations: Past performance Present condition Future performance Assess the organisations: Earnings in terms of power, persistence, quality and growth Solvency

Hermanto

Effective Financial Statement Analysis

To perform an effective financial statement analysis, you need to be aware of the organisations:
business strategy objectives annual report and other documents like articles about the organisation in newspapers and business reviews. These are called individual organisational factors.

Hermanto

Effective Financial Statement Analysis

Requires that you: Understand the nature of the industry in which the organisation works. This is an industry factor. Understand that the overall state of the economy may also have an impact on the performance of the organisation. Financial statement analysis is more than just crunching numbers; it involves obtaining a broader picture of the organisation in order to evaluate appropriately how that organisation is performing
Hermanto

Tools of Financial Statement Analysis:

The commonly used tools for financial statement analysis are: Financial Ratio Analysis Comparative financial statements analysis:
Horizontal analysis/Trend analysis Vertical analysis/Common size analysis/ Component Percentages

Hermanto

Financial Ratio Analysis

Financial ratio analysis involves calculating and analysing ratios that use data from one, two or more financial statements. Ratio analysis also expresses relationships between different financial statements. Financial Ratios can be classified into 5 main categories:
Profitability Ratios Liquidity or Short-Term Solvency ratios Asset Management or Activity Ratios Financial Structure or Capitalisation Ratios Market Test Ratios

Hermanto

Profitability Ratios
3 elements of the profitability analysis: Analysing on sales and trading margin
focus on gross profit

Analysing on the control of expenses

focus on net profit

Assessing the return on assets and return on equity

Hermanto

Profitability Ratios
Gross Profit % = Gross Profit * 100 Net Sales Net Profit % = Net Profit after tax * 100 Net Sales Or in some cases, firms use the net profit before tax figure. Firms have no control over tax expense as they would have over other expenses.
Net Profit % = Net Profit before tax *100 Net Sales

Return on Assets =

Net Profit Average Total Assets Net Profit Average Total Equity

* 100

Return on Equity =

*100

Hermanto

Liquidity or Short-Term Solvency ratios

Short-term funds management Working capital management is important as it signals the firms ability to meet short term debt obligations. For example: Current ratio

The ideal benchmark for the current ratio is $2:$1 where there are two dollars of current assets (CA) to cover $1 of current liabilities (CL). The acceptable benchmark is $1: $1 but a ratio below $1CA:$1CL represents liquidity riskiness as there is insufficient current assets to cover $1 of current liabilities.

Hermanto

Liquidity or Short-Term Solvency ratios

Working Capital = Current assets Current Liabilities Current Ratio = Current Assets Current Liabilities

Quick Ratio = Current Assets Inventory Prepayments Current Liabilities Bank Overdraft

Hermanto

Asset Management or Activity Ratios

Efficiency of asset usage
How well assets are used to generate revenues (income) will impact on the overall profitability of the business.

For example: Asset Turnover

This ratio represents the efficiency of asset usage to generate sales revenue

Hermanto

Asset Management or Activity Ratios

Asset Turnover = Net Sales Average Total Assets Cost of Goods Sold Average Ending Inventory

Inventory Turnover =

Average Collection Period = Average accounts Receivable Average daily net credit sales*
* Average daily net credit sales = net credit sales / 365
Hermanto

Financial Structure or Capitalisation Ratios

Long term funds management Measures the riskiness of business in terms of debt gearing. For example: Debt/Equity This ratio measures the relationship between debt and equity. A ratio of 1 indicates that debt and equity funding are equal (i.e. there is $1 of debt to $1 of equity) whereas a ratio of 1.5 indicates that there is higher debt gearing in the business (i.e. there is $1.5 of debt to $1 of equity). This higher debt gearing is usually interpreted as bringing in more financial risk for the business particularly if the business has profitability or cash flow problems.

Hermanto

Financial Structure or Capitalisation Ratios

Debt/Equity ratio = Debt / Equity Debt/Total Assets ratio = Debt *100 Total Assets

Equity ratio =

Equity *100 Total Assets

Times Interest Earned = Earnings before Interest and Tax Interest

Hermanto

Market Test Ratios

Based on the share market's perception of the company.
For example: Price/Earnings ratio The higher the ratio, the higher the perceived quality of the earnings by the share market.

Hermanto

Market Test Ratios

Earnings per share = Net Profit after tax
Number of issued ordinary shares

Dividends per share =

Dividends

Number of issued ordinary shares

Dividend payout ratio = Dividends per share *100 Earnings per share Price Earnings ratio = Market price per share Earnings per share
Hermanto

Horizontal analysis/Trend analysis

Trend percentage Line-by-line item analysis Items are expressed as a percentage of a base year This is a time series analysis For example, a line item could look at increase in sales turnover over a period of 5 years to identify what the growth in sales is over this period.
Hermanto

Vertical analysis/Common size analysis/ Component Percentages

All items are expressed as a percentage of a common base item within a financial statement e.g. Financial Performance sales is the base e.g. Financial Position total assets is the base Important analysis for comparative purposes
Over time and For different sized enterprises

Hermanto

Limitations of Financial Statement Analysis

We must be careful with financial statement analysis.
Strong financial statement analysis does not necessarily mean that the organisation has a strong financial future. Financial statement analysis might look good but there may be other factors that can cause an organisation to collapse.

Hermanto

Illustration: Financial statement analysis

The following financial statements of Walker Ltd were prepared in accordance with New Zealand GAAPs. Walker Ltd is a diversified enterprise with its main interests in the manufacture and retail of plastic products. The financial statements of Walker Ltd need to be analysed. An investor is considering purchasing shares in the company. Relevant ratios need to be selected and calculated and a report needs to be written for the investor. The report should evaluate the companys performance and position
Hermanto

Walker Ltd Statement of Financial Position as at 31 March

2005 $000 Current Assets Bank Accounts receivable Inventory Non-current assets Fixtures & fittings (net) Land & buildings (net) Total assets Current Liabilities Accounts payable Income tax Non-current liabilities Loan Shareholders Funds Paid-up ordinary capital Retained profit Total liabilities & equity 33.5 240.8 300.0 574.3 64.6 381.2 445.8 1,020.1 63.2 376.2 439.4 1,061.4 99 104 $000 $000 41.0 210.2 370.8 622.0 108 2006 $000 Horizontal Analysis

261.6 60.2 321.8 200.0

288.8 76.0 364.8 60.0 113 30

300.0 198.3 498.3 1,020.1

334.1 302.5 636.6 1,061.4 128 104

Hermanto

Walker Ltd Statement of Financial Performance for year ended 31 March

2005 $000 Sales Less Cost of goods sold Gross profit Wages & salaries Rates Heat & light Insurance Interest expense Postage & telephone Depreciation Buildings Fixtures & fittings Net profit before tax Less Income tax Net profit after tax $000 2,240.8 1,745.4 495.4 $000 2006 $000 2,681.2 2,072.0 609.2 Horizontal Analysis 120 119 123

185.8 12.2 8.4 4.6 24.0 9.0 5.0 27.0

275.6 12.4 13.6 7.0 6.2 16.4 5.0 32.8

276.0 219.4 60.2 159.2

369.0 240.2 76.0 164.2

134 109 126 103

Hermanto

Walker Ltd Statement of Cash Flows for the year ended 31 March
2005 $000 Cash flow from operations Receipts from customers Payments to suppliers & employees Interest paid Tax paid Net cash flow from operating activities Investing activities Purchase of non-current assets Net cash used in investing activities Financing activities Dividends paid Issue of ordinary shares Repayment of loan capital Net cash outflow from financing activities Increase in cash & cash equivalents 2,281 (2,050) (24) (46.4) 160.6 (121.2) (121.2) (32.0) 20.0 -__ (12) 27.4 (40.2) 34.1 (140.0) (146.1) 7.5 (31.4) (31.4) $000 $000 2,711.8 (2,460.4) (6.2) (60.2) 185 2006 $000

Hermanto

Additional information:
Credit purchases for the year 2006 were $2,142,800. General prospects for the major industries in which Walker is involved look good with a forecast glut of oil set to reduce the cost of production and world demand for plastic remaining strong. Benchmarks: There are no exact benchmarks for Walker Ltd because it is a diversified company. The following are average indicators that relate to the plastic retailing and manufacturing industries for the year 2006.
Gross profit margin Net profit margin Inventory turnover Debt/equity ratio Return on Assets Return on Equity 25% 7% 6 times 0.6 : 1 12% 20%
Hermanto

Relevant ratios
Important note: The calculations of the ratios in this illustration did not use averages for total assets, equity and inventory. The 2005 and 2006 year end figures were used and this is a slight variation to the formulas provided.

Profitability ratios: Gross Profit Margin Net Profit Margin Return on Assets Return on Equity

Benchmarks

2005

2006

Industry 25% Industry 7% 12%

22%

22.7%

7.1%

6.1%

15.6%

15.5%

Industry 20%

32%

26%

Hermanto

Asset Management ratios: Inventory Turnover Asset Turnover

Benchmarks

2005

2006

Industry 6% Not given

5.8 times

5.58 times

2.2

2.53

Hermanto

Liquidity ratios: Current Ratio

Benchmarks
Ideal standard 2:1 Acceptable standard 1:1

2005 1.78:1

2006 1.70:1

Quick Ratio

Ideal standard 2:1 Acceptable standard 1:1

0.85:1

0.69:1

Days Payable

Standard 30 days

Credit purchases not available

49.19 days

Hermanto

Financial Structure ratios: Debt/Equity

Benchmarks

2005

2006

Industry 0.6:1 Standard benchmark 1:1 Standard benchmark: Between 3 and 5. Below 3 risky. Above 5 very favourable

1.05: 1

0.67:1

TIE

10.14 times

39.74 times

Hermanto

Report
For the investor considering the purchase of shares in the company, the return they will earn is the key financial factor but an overall evaluation of the companys performance and position is also important to get a better picture of how well the company is actually doing. ROE in 2006 is 26%. Whether or not this is attractive depends on the perceived riskiness of this investment and other alternatives available but this return is certainly more attractive than current bank interest rates. ROE has decreased by 4% but the companys ROE at 26% is still better than the industry average of 20% Riskiness of business is being reduced by the significant repayment of loan in 2006.

Hermanto

 Profitability
The NP% and ROA ratios show a small downward trend in % over the 2 year period. ROE% ratio show a more significant decrease but is still better than the industry average. Gross Profit Margin is slightly unfavourable at about 2.3% below the industry benchmark of 25%. The horizontal analysis information show that Sales have increased by 20%. However operating costs have increased by 34%.

Asset Management
IT has gone down slightly from 5.8 to 5.58 times. IT is still close to the industry benchmark of 6 times. AT has increased showing more sales being generated from asset usage
Hermanto

 Liquidity
Current ratios of 1.78:1 (2005) and 1.70: 1 are at above acceptable levels but below ideal level. Quick ratios appear more of a concern being below acceptable levels in both years and even more so in 2006 (0.69:1). Raises some concerns over the liquidity of the business and inventory management (although IT ratio only shows a slight decline in 2006). Days Payable is a concern as there may be poor debt payment management.

Hermanto

 Financial Structure
Although slightly higher than D/E industry benchmark (0.67:1), business has become less risky due to the significant repayment of loan in 2006. TIE is extremely good for the business at 39.74 times (well above 5 the standard benchmark).

Cash flow situation

Strong cash flow from operating activities (increased from 160,600 to 185,000). Spending under investing activities suggest more growth. Repayment of debt under financing activities imply restructuring of business to have more equity funding rather than debt funding.

Hermanto

Recommendation
Given: 1) the strong forecast for the industry (ie general prospects looking good and world demand for plastic products remaining strong), 2) the sales growth in this business, 3) acceptable ratios as they are quite close to the industry averages, 4) good cash flows from operating activities and 5) favourable ROE, although it has decreased, it is still better than the industry average ROE.
=> it is recommended that the investor purchase shares in the Walker Ltd company.
Hermanto