Fundamentals of financial statement analysis. (Lecture 1) презентация

LEARNING OBJECTIVES
Understand and conduct horizontal analysis
Create, understand, and interpret common-size financial statements.
Calculate and interpret financial ratios.
Compare different company performances, using financial ratios, historical financial ratio trends, and industry ratios.

I. Overview of Financial Statements

TYPES OF FINANCIAL STATEMENTS
Balance Sheet
Income Statement
Statement of Cash Flows
Statement of Changes in the Owner’s Equity

BALANCE SHEET
Assets
Liabilities
Equity
=
+
Statement of financial position
Statement of financial Condition
The balance sheet provides a snapshot of a firm’s
financial position at a particular date.
assets ≡ liabilities + owners’ equity

INCOME STATEMENT (P/L STATEMENT)
It is also known as Profit/Loss Statement, Operating Statement, or Statement of Operations
It measures the results of firm’s operation over a specific period.
The bottom line of the income statement shows the firm’s profit or loss for a period.

INCOME STATEMENT (P/L STATEMENT)
Total Sales / Revenues
Cost of Goods Sold (COGS)
Gross Profit
Operating Expenses
Operating Income
Other Income/Other expenses
Earnings before Interest and Taxes ( EBIT)
Interest Income / Interest Expenses
Earnings Before Taxes (EBT) or Pre-Tax Income
Taxes
Net Income
-
=
-
=
+/-
=
-
=
+/-
=

CASH FLOWS STATEMENT
Cash flows from Operations
Cash flows from Investments
Cash flows from Financing
Net change in cash
Cash Flows Statement shows:
how cash was generated, and
how it was used.
+
+
=

STATEMENT OF OWNER’S EQUITY
Statement of Changes in the Owner’s Equity is a financial statement that presents a summary of the changes in owners’ equity accounts over the reporting period. It reconciles the opening balances of equity accounts with their closing balances.
Figures used to compile this statement are derived from previous and current Balance Sheets and from the current Income Statement.

Stockholders’ (Owners’) Equity accounts
Owners’ investment in the corporation through the ownership of stock
Owners’ claims to the assets of a corporation
Common Stock
Net income (loss) earned over the company’s lifetime, minus dividends
Retained Earnings
Dividends
Distribution to stockholders

Stockholders’ (Owners’) Equity accounts
Increase in stockholders’ equity from delivering goods or services to customers (revenues are embedded in Balance sheet through Retained earnings and classified as Income statement accounts)
Owners’ claims to the assets of a corporation
Revenues
Expenses
Decrease in stockholders’ equity due to the cost of operating the business (expenses are embedded in Balance sheet through Retained earnings and classified as Income statement accounts)

(1) Increases in stockholders’ equity: Sale of stock and net income (revenue greater than expenses).
(2) Decreases in stockholders’ equity: Dividends and net loss (expenses greater than revenue).

II. ANALYSIS OF FINANCIAL STATEMENTS

APPROACHES TOWARDS FINANCIAL ANALYSIS
To conduct financial analysis it is possible to
Compare actual with budgeted values
Compare a firm’s current performance against that of its own performance (and/or of the performance of other companies in the industry) over a certain time period by looking at the growth (decline) rate in various key items such as sales, costs, and profits (trend analysis). Once trends are established, future performance could be predicted.
Recast the income statement and the balance sheet into common-size statements by expressing each income statement item as a percent of sales and each balance sheet item as a percent of total assets.
Conduct ratio analysis. This allows for more in-depth diagnosis through individual item analyses and comparisons
Setting up a standard of comparison is a benchmarking.

PERFORMANCE ANALYSIS:
BUDGETED VS. ACTUAL

PERFORMANCE ANALYSIS:
BUDGETED VS. ACTUAL

HORIZONTAL (TREND) ANALYSIS
Type 1: Percentage changes from year-to-year
Two steps:
Compute dollar (or any currency) amount of change from one period to the next
Divide dollar (or any currency) amount of change by base-period amount

Illustration: Amazon.com, Inc.
Step 1 Compute the dollar amount of change from 2011 to 2012
Step 2 Percentage change for the period
Amazon.com’s net sales (in millions) increased by 27.1% during 2012, computed as follows:

Illustration: Amazon.com, Inc.
Comparative Consolidated Statements of Operations—Horizontal Analysis (partial exhibit)

Illustration: Amazon.com, Inc.
Consolidated Balance Sheets—Horizontal Analysis (partial exhibit)

Illustration
Prepare a horizontal analysis of the comparative income statements of Ama Music Co.

HORIZONTAL (TREND) ANALYSIS
Type 2: Trend Percentages
Base year selected and set equal to 100%
Amount of each following year stated as a percent of base

HORIZONTAL (TREND) ANALYSIS
Type2: Trend Percentages
Amazon.com, Inc., showed income from operations as follows:
Trend percentages are computed by dividing each successive year’s amount by the 2008 amount

HORIZONTAL (TREND) ANALYSIS
Type 3: Used to find an average growth (declining) rate and to find an expected value of an account

HORIZONTAL (TREND) ANALYSIS
Cogswell Cola’s Abbreviated Income Statements ($ in thousands)

VERTICAL ANALYSIS
Shows relationship of a financial-statement item to its base
Income statement, base is total revenue
Balance sheet, base is total assets

Illustration: Amazon.com, Inc.
Comparative Consolidated Statements of Operations—Vertical Analysis (partial exhibit)

Illustration: Amazon.com, Inc.
Consolidated Balance Sheets—Vertical Analysis (partial exhibit)

COMMON-SIZE FINANCIAL STATEMENTS
Type of vertical analysis
Report only percentages (no dollar amounts)
Assists in the comparison of different companies
Expresses financial results in terms of a common denominator

Calculate the common-size percentages
for the following income statement:

FINANCIAL RATIO ANALYSIS
Financial ratios are relationships between different accounts from financial statements (due to this they are relative values)
Financial ratios allow for meaningful comparisons across time, between competitors, and with industry averages.

FINANCIAL RATIO ANALYSIS
Firm’s performance can be analyzed by using five key sets of financial ratios:
Profitability ratios: How well has the company performed overall?
Liquidity ratios: Can the company meet its obligations over the short term?
Solvency ratios (also known as financial leverage ratios): Can the company meet its obligations over the long term?
Activity ratios are designed to show how effectively a company employs the resources
Investment Valuation Ratios / Market value ratios: How does the market (investors) view the company’s financial prospects?

PROFITABILITY RATIOS

NET INCOME AS A % OF SALES (NET PROFIT MARGIN)

RETURN ON ASSETS (ROA)

RETURN ON EQUITY (ROE)

LIQUIDITY RATIOS /
SHORT-TERM SOLVENCY RATIOS

CURRENT RATIO

QUICK RATIO OR ACID RATIO TEST

SOLVENCY RATIOS /
FINANCIAL LEVERAGE RATIOS

FINANCIAL LEVERAGE RATIOS
In the area of financial leverage, Company A is in a much better position than Company B, since it has relatively less debt and a significantly greater ability to cover its interest obligations by using either its EBIT (times interest earned ratio) or its net cash flow (cash coverage ratio).

ACTIVITY / ASSET MANAGEMENT RATIOS
These ratios measure how efficiently a firm is using its assets to generate revenues or how much cash is being tied up in other assets such as receivables and inventory.
Total Assets Turnover Ratio
Fixed Asset Turnover Ratio
Inventory Turnover
Account Receivable Turnover

TOTAL ASSETS TURNOVER RATIO / MANAGEMENT EFFICIENCY RATIO

FIXED ASSET TURNOVER RATIO

INVENTORY TURNOVER

INVENTORY TURNOVER
A lower inventory turnover ratio may be an indication of over-stocking which may pose risk of obsolescence and increased inventory holding costs.
A very high value of this ratio may be accompanied by loss of sales due to inventory shortage.
Inventory turnover is different for different industries. Businesses which trade perishable goods have very higher turnover compared to those dealing in durables. Hence a comparison would only be fair if made between businesses of same industry.

INVENTORY TURNOVER

INVENTORY TURNOVER
A low turnover is usually a bad sign because products tend to deteriorate as they sit in a warehouse.
Companies selling perishable items have very high turnover.
For more accurate inventory turnover figures due to fluctuation in the level of inventory throughout the year, the average inventory figure [(beginning inventory + ending inventory)/2] is used when computing inventory turnover. Average inventory accounts for any seasonality effects on the ratio.

RECEIVABLE TURNOVER

RECEIVABLE TURNOVER
Accounts receivable turnover measures the efficiency of a business in collecting its credit sales. Generally a high value of accounts receivable turnover is favorable and lower figure may indicate inefficiency in collecting outstanding sales. Increase in accounts receivable turnover overtime generally indicates improvement in the process of cash collection on credit sales.
However, a normal level of receivables turnover is different for different industries. Also, very high values of this ratio may not be favourable, if achieved by extremely strict credit terms since such policies may repel potential buyers.

Example: Total sales of Company A during the year ended December 31, 2013 were $984,000. Customers returned goods invoiced at $31,400 during the year. Average accounts receivable during the period were $23,880. Calculate accounts receivable turnover ratio and explain it.
Solution
Net Sales = $984,000 − $31,400 = $952,600
Receivables Turnover = $952,600 ÷ $23,880 ≈ 39.89 times
365/39,89 ≈ 9 days is required to collect all receivables
RECEIVABLE TURNOVER

INVESTMENT VALUATION RATIOS /
MARKET VALUE RATIOS
Investment valuation ratios are used by investors to estimate the attractiveness of a potential or existing investment and get an idea of its valuation.
Key ratios are:
Earning per Share
Price to Earnings Ratio (P/E Ratio)
Price / Earning to Growth Ratio (PEG Ratio)
Market to Book value (Price to Book Ratio)
Typically, if a firm has a high price-to-earnings and a high market-to-book value ratio, it is an indication that investors have a good perception about the firm’s performance.
However, if these ratios are very high, it could also mean that a firm is overvalued.

EARNINGS PER SHARE

PRICE PER EARNINGS (P/E) RATIO

PRICE / EARNING TO GROWTH RATIO
(PEG RATIO)

PRICE / EARNING TO GROWTH RATIO
(PEG RATIO)
Example: Company A is currently trading with a P/E ratio of 30. Typically, this would be considered an "expensive" stock.
Assume that an expected growth in earnings per share of +40% for the next year.
In this case, Company A’s PEG ratio would be:
PEG Ratio = 30 / +40% = 0.75
A rule of thumb is that any PEG ratio below 1.0 is considered to be a good value. So even though XYZ is highly valued based on the P/E ratio, the PEG ratio says that it is undervalued relative to its growth potential.

MARKET TO BOOK VALUE
(PRICE TO BOOK RATIO)

To be useful, ratios should be analyzed over a period of years to consider all relevant factors
Any one year, or even any two years, may not represent the company’s performance over the long term
Limitations of Ratio Analysis