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PERFORMANCE ANALYSIS
(Tools for Financial Analysis and Control)
Responsibilities of the Financial Manager
F
i
n
a
1. Managing the
n working capital 2. Estimating the
c seasonal fund needs
i
a
l 3. Long-term financial
planning: forecasting long-
M
a term fund requirements
n
a
g
e 4. Determining appropriate
r investment mix
6. Determining the
amount of dividends 5. Determining appropriate
to be paid financing mix
2
Inter-relationships between financing,
investment and dividend decisions
Investment: Finance: Company Dividends: if finance is
Company decides to will need to raise not available from
take on a large finance in order to external sources,
number of attracting take on projects dividends may need to be
new investment cut in order to increase
projects internal financing
Dividends: company Finance: lower level Investment: if finance is
decides to pay higher of retained earnings not available from
levels of dividends to available for external sources the
shareholders investment means company may have to
company may have to postpone future
find finance from investment projects
external sources
Finance: company Investment: due to Dividends: the
finances itself using a higher cost of company’s ability to pay
more expensive capital the number of dividends in the future
sources resulting in a projects attractive to will be adversely affected
higher cost of capital the company
decreases
Learning Activity
• What are the basic financial statements that
should be prepared by a business firm?
• What are the uses of each of the basic
financial statements?
Basic Financial Statements
Government
Creditors
Employees Customers
The firm
Managers Society
Shareholders
Financial Statement Analysis
• What do internal users use it for?
Planning, evaluating and controlling company
operations
• What do external users use it for?
Assessing past performance and current financial
position and making predictions about the future
profitability and solvency of the company as well
as evaluating the effectiveness of management
Financial Statement Analysis
Information is available from
– Published annual reports
(1) Financial statements
(2) Notes to financial statements
(3) Letters to stockholders
(4) Auditor’s report (Independent accountants)
(5) Management’s discussion and analysis
Financial Statement Analysis
Information is available from (Cont…)
– Other sources
(1) Newspapers (e.g., Business Times, Financial Times )
(2) Periodicals (e.g. Forbes, Fortune)
(3) Financial information organizations such as:
Moody’s, Standard & Poor’s, Dun & Bradstreet, Inc.,
and Robert Morris Associates
(4) Other business publications
Methods of
Financial Statement Analysis
• Horizontal Analysis
• Vertical Analysis
• Common-Size Statements
• Trend Percentages
• Ratio Analysis
Horizontal Analysis
28
UD Co Ltd
Comparative Balance Sheets
December 31, 2014 and 2013
Increase
(Decrease)
2014 2013 Amount %
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable $ 67,000 $ 44,000 $ 23,000 52.3
Notes payable 3,000 6,000 (3,000) (50.0)
Total current liabilities 70,000 50,000 20,000 40.0
Long-term liabilities:
Bonds payable, 8% 75,000 80,000 (5,000) (6.3)
Total liabilities 145,000 130,000 15,000 11.5
Stockholders' equity:
Preferred stock 20,000 20,000 - 0.0
Common stock 60,000 60,000 - 0.0
Additional paid-in capital 10,000 10,000 - 0.0
Total paid-in capital 90,000 90,000 - 0.0
Retained earnings 80,000 69,700 10,300 14.8
Total stockholders' equity 170,000 159,700 10,300 6.4
Total liabilities and stockholders' equity $ 315,000 $ 289,700 $ 25,300 8.7
Horizontal Analysis Example
• Now, let’s apply the procedures to the
income statement
30
UD Co Ltd
Comparative Income Statements
For the Years Ended December 31, 2014 and 2013
Increase (Decrease)
2014 2013 Amount %
Net sales $ 520,000 $ 480,000 $ 40,000 8.3
Cost of goods sold 360,000 315,000 45,000 14.3
Gross margin 160,000 165,000 (5,000) (3.0)
Operating expenses 128,600 126,000 2,600 2.1
Net operating income 31,400 39,000 (7,600) (19.5)
Interest expense 6,400 7,000 (600) (8.6)
Net income before taxes 25,000 32,000 (7,000) (21.9)
Less income taxes (30%) 7,500 9,600 (2,100) (21.9)
Net income $ 17,500 $ 22,400 $ (4,900) (21.9)
UD Co Ltd
Comparative Income Statements
For the Years Ended December 31, 2014 and 2013
Increase (Decrease)
2014 2013 Amount %
Net sales $ 520,000 $ 480,000 $ 40,000 8.3
Cost of goods sold 360,000 315,000 45,000 14.3
Gross margin 160,000 165,000 (5,000) (3.0)
Operating expenses 128,600 126,000 2,600 2.1
Net operating income 31,400 39,000 (7,600) (19.5)
Interest expense 6,400 7,000 (600) (8.6)
Net income before taxes 25,000 32,000 (7,000) (21.9)
Less income taxes (30%) 7,500 9,600 (2,100) (21.9)
Net income $ 17,500 $ 22,400 $ (4,900) (21.9)
MD Co Ltd
Operating Data
2014 2013 2012 2011 2010
Revenues 132% 123% 116% 109% 100%
Expenses 120% 116% 110% 106% 100%
Net income 313% 234% 203% 158% 100%
CAUTION!
“Using ratios and percentages without
considering the underlying causes may
lead to incorrect conclusions.”
Major Categories of Ratios
• Liquidity Ratios
Indicate a company’s short-term debt-paying ability
• Asset Management
Measure how effectively the firm is managing/using its
assets
• Equity (Long-Term Solvency) Ratios
Show relationship between debt and equity financing
in a company
• Profitability Tests
Relate income to other variables
• Market Tests
Help assess relative merits of stocks in the market place
The 10 Basic Ratios you have to know
• Liquidity Ratios
1. Current Ratio (Working Capital Ratio)
2. Quick Ratio/Acid Test Ratio
Cash Ratio/Cash Flow liquidity Ratio
• Asset Management Ratios
3. Inventory Turnover Ratio
4. Days Sales Outstanding
5. Inventory Turnover Ratio
Fixed Assets Turnover Ratio
Total Assets Turnover Ratio
• Equity (Long-term solvency/Debt Management Ratios
6. Equity (stockholders’ equity) ratio - Equity to debt
Total Debt to Total Assets Ratio
Times Interest Covered Ratio
The 10 Basic Ratios you have to know
• Profitability Ratios
7. Profit Margin - Net income to net sales (return on sales)
8. Earnings per share
9. Return on average common stockholders’ equity (ROE)
• Return on Assets
• Return on Equity
• Basic Earning Power Ratio
• Cash flow margin
• Times interest earned
• Times preferred dividends earned
The 10 Basic Ratios you have to know
• Market Tests
10. Price-earnings ratio
• Earnings yield on common stock
• Payout ratio on common stock
• Dividend yield on common stock
• Dividend yield on preferred stock
• Cash flow per share of common stock
Ratio Analysis - Example
Neema Co Ltd
Balance Sheets
December 31, 2013 and 2012
2013 2012
Assets
Current assets:
Cash $ 30,000 $ 20,000
Accounts receivable, net 20,000 17,000
Inventory 12,000 10,000
Prepaid expenses 3,000 2,000
Total current assets 65,000 49,000
Property and equipment:
Land 165,000 123,000
Buildings and equipment, net 116,390 128,000
Total property and equipment 281,390 251,000
Total assets $ 346,390 $ 300,000
Neema Co Ltd
Balance Sheets
December 31, 2013 and 2012
2013 2012
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable $ 39,000 $ 40,000
Notes payable, short-term 3,000 2,000
Total current liabilities 42,000 42,000
Long-term liabilities:
Notes payable, long-term 70,000 78,000
Total liabilities 112,000 120,000
Stockholders' equity:
Common stock, $1 par value 27,400 17,000
Additional paid-in capital 158,100 113,000
Total paid-in capital 185,500 130,000
Retained earnings 48,890 50,000
Total stockholders' equity 234,390 180,000
Total liabilities and stockholders' equity $ 346,390 $ 300,000
Neema Co Ltd
Income Statements
For the Years Ended December 31, 2013 and 2012
2013 2012
Net sales $ 494,000 $ 450,000
Cost of goods sold 140,000 127,000
Gross margin 354,000 323,000
Operating expenses 270,000 249,000
Net operating income 84,000 74,000
Interest expense 7,300 8,000
Net income before taxes 76,700 66,000
Less income taxes (30%) 23,010 19,800
Net income $ 53,690 $ 46,200
Ratio Analysis - Example
• Calculate the 10 basic ratios based on Neema
Co Ltd’s financial statements
Neema Co Ltd
2014
Cash $ 30,000
Accounts receivable, net
information Inventory
12/31/14
Current assets $ 65,000
Current liabilities (42,000)
Working capital $ 23,000
Inventory $140,000
= = 12.73 times
Turnover ($10,000 + $12,000) ÷ 2
Inventory $140,000
= = 12.73 times
Turnover ($10,000 + $12,000) ÷ 2
Equity $234,390
= = 67.7%
Ratio $346,390
Net Income
$53,690
To Net Sales = = 10.9%
$494,000
Net Income
= $53,690
To Net Sales = 10.9%
$494,000
Return on
$53,690
Stockholders’ = = 25.9%
($180,000 + $234,390) ÷ 2
Equity
Earnings $53,690
= = $2.42
per Share (17,000 + 27,400) ÷ 2
Net Income
Equity
– This represents amount of profit per Tshs invested
by the shareholders.
75
DuPont System – What is It?
• The system identifies profitability as being impacted by
three different levers:
– Earnings & efficiency in earnings Earnings
– Ability of your assets to be turned into profits Efficiency
76
Net Total
ROE Profit Asset Debt
Margin Turnover Ratio
Net Income Net Income Sales Total Assets
= X X
Total Equity Sales Total Assets Total Equity
Asset Usage
Profitability Efficiency Leverage
77
78
The DuPont System
ROE
79
The DuPont System
ROE
Notice that using more debt (and less equity) to finance assets
raises the Equity Multiplier. This has two effects for stockholders.
At the same time, Return on Assets can be raised by producing sales by using fewer
assets. Asset Turnover measures the sales produced with each shilling invested in
assets. This is often thought of as sales volume.
Different industries achieve ROA in different ways. Some have low profit margins
but high volume, e.g. grocery stores. Others have lower volume but are able to
maintain higher profit margins, e.g. car dealerships. 81
The DuPont System
ROE
82
DuPont Equation
83
DuPont System
Earnings/Profitability
Operating
Profit Margin
Return On
Income X = Assets (less
Stream interest adj.)
Asset
Turnover Return On
X =
Equity
Asset Efficiency Usage
Financial
Investment
Structure
Stream
Leverage
84
DuPont System Ratios
Profitability
Operating
Profit Margin
Return On
Income X = Assets (less
Stream interest adj.)
Asset
Turnover Return On
X =
Equity
Efficiency
Financial
Investment
Structure
Stream
Leverage
85
Problems in Financial Statement and
Ratio Analysis
• Developing and Using Comparative Data
• Distortion of Comparative Data
• Notes to Financial Statements
• Interpretation of Results
• Differences in Accounting Treatment
• Window Dressing
• Effects of Inflation
Important Considerations
• Need for comparable data
– Data is provided by companies such as Dun &
Bradstreet, Standard & Poor’s etc.
– Must compare by industry
– Is EPS comparable?