Week 6 Financial Statement Analysis Readings: Chapter 8

1. Week 6 Financial Statement Analysis Readings: Chapter 8

2. Learning Objectives • Identify why different user groups require financial statements to be analysed and interpreted • Describe the nature and purpose of financial analysis • Apply the analytical methods of horizontal, trend, vertical and ratio analysis

3. Learning Objectives • Define, calculate and analyse the ratios that measure profitability, asset efficiency, liquidity, capital structure and market performance • Explain the interrelationships between ratios • Discuss the limitations of ratio analysis

4. Why Analyse? • We have spent the last 3 weeks looking at the presentation and preparation of financial statements: • The balance sheet • The income statement • The statement of changes in equity • The statement of cash flows • This week we consider using these financial statements to assess the past performance and position of the business, and to form opinions as to the future.

5. Users and Decision Making • The users of financial reports can broadly be categorised as: • resource providers e.g., creditors, lenders, shareholders, employees • recipients of goods and services i.e., customers, debtors • parties performing an overview or regulatory function e.g., tax office, corporate regulator, statistical bureaus • internal management to assist in their decision making duties

6. Nature and Purposeof Financial Analysis • Financial analysis involves expressing the reported numbers in relative terms rather than relying on the absolute numbers • For example stating that profit is $250,000 (an absolute term) is meaningless, without a comparison. • If you were told that profit was $400,000 last year, then $250,000 this year is not great. • If we found profit as a percentage of total assets and the percentage had increased from last year, this would be a good trend.

7. Nature and Purposeof Financial Analysis (cont) • This type of financial analysis can highlight the strengths and weaknesses of firms • By evaluating an entity’s financial past users are in a better position to form an opinion as to the entity’s future financial health • It is essential in financial analysis to compare figures with: • the equivalent figures from previous years (rather than in one year’s absolute terms) • other figures in the financial statements

8. Analytical Methods • Analytical methods include • Horizontal analysis • Trend analysis • Vertical analysis • Ratio analysis • Benchmarks

9. Horizontal analysis • Compares reported numbers in different reporting periods to highlight magnitude and significance of changes • Dollar change is calculated by: • Percentage change is calculated by: Accounting number in current reporting period – Accounting number in previous reporting period Accounting number in current reporting period –Accounting number in previous reporting period x 100 Accounting number previous reporting period

10. Activity 6.1 • Complete a horizontal analysis for the Balance Sheet provided on the handout (also available on Blackboard).

11. Trend Analysis • Tries to predict the future direction of various items on the basis of the direction of the items in the past • To calculate a trend, it is necessary to have at least three years of data • Trend analysis of a particular item involves expressing the item in subsequent years, relative to a selected base year – which is usually given a value of 100

12. Example : Converting Sales Revenue for a trend analysis Set 2006 as base year and assign it index value of 100 Divide 2007 revenue by 2006 revenue and x by 100 Divide 2008 revenue by 2006 revenue and x by 100 Divide each subsequent year’s revenue by 2006 revenue and x 100 Trend Analysis example

13. We can repeat this process for EBIT and profit and end up with table below Analysing the trend figures, we can easily see that sales revenue, EBIT and profit have increased each year during 2006–10, but EBIT and profit fell in 2011 Trend Analysis (cont)

14. Trend Analysis (cont)

15. Vertical Analysis • Involves comparing the items in a financial statement to an anchor item in the same financial statement: • Revenue and expense items (income statement items) are expressed as a percentage of sales or revenue (this is the base amount or anchor) • Asset, liability and equity items (balance sheet items) are expressed as a percentage of total assets (this is the base amount or anchor) • When expressed this way, the financial statements are often referred to as common size statements

16. JB Hi-Fi Ltd Prepared by Simon Lenthen University of Western Sydney

17. JB Hi-Fi Ltd

18. Activity 6.2 • Complete a vertical analysis for the Income Statement provided on the handout (available on Blackboard).

19. Ratio Analysis • An expression of one item in the financial statements as another item in the financial statements – one item is divided by another to create the ratio • The ratio comparison can be between two different statements • But income statement and statement of cash flows involve flow items while balance sheet reports stock items

20. Ratio Analysis (cont) • Ratio analysis is a 3-step process • Calculate a meaningful ratio by expressing $ amt of an item by $ amount of another item • Compare the ratio with a benchmark • Interpret the ratio and seek to explain why it differs • from previous years • from comparative entities or • from industry averages

21. Ratio Analysis (cont) • Ratios in various categories help users in their decision making • profitability ratios • efficiency ratios • liquidity ratios • capital structure ratios • market performance ratios (relevant to companies listed on an organised stock exchange)

22. Benchmarks • Ratios are of limited usefulness unless compared to relevant benchmarks • Comparisons may be made of: • the entity’s ratios over time (identify trends) • the entity’s ratios with those of other entities in same industry (intra-industry analysis) • the entity’s ratios with industry averages • the entity’s ratios with those of entities operating in different industries (inter-industry analysis) • the entity’s ratios with arbitrary standards

23. Return on equity (ROE) Profit available to owners x 100 = x% Average owners’ equity Profitability Analysis • Return on equity (ROE) • Captures profitability (measures the profit generated for shareholders as a % of their investment) • Upward trend is advantageous for entity • But, a sustained high ROE attracts new competitors to industry and eventually erodes excess ROE

24. Profitability Analysis • Note: where you are required to use an average: Average owners’ equity = Owners’ equity last year + Owners’ equity this year 2

25. Return on assets (ROA) EBIT x 100 = x% Average assets Profitability Analysis (cont) • Return on assets (ROA) • Reflects the results of entity’s ability to generate profit from their assets (measured as a %) • Higher is preferred • EBIT = Earnings (profit) before interest expense and tax expense

26. Gross profit margin Gross profit x 100 = x% Sales revenue Profitability Analysis (cont) • Profit margin ratios • Ratios that relate profit to sales revenue generated by the entity • Higher is preferred • Gross profit margin measures the % of gross profit generated from each dollar of sales (gross profit = sales revenue less cost of sales)

27. Profit margin Cash flow to sales ratio EBIT x 100 = x% Sales revenue Cash flow from operating activities x 100 = x% Sales revenue Profitability Analysis (cont)

28. Profitability Analysis (cont)

29. Profitability Analysis (cont)

30. Profitability Analysis (cont)

31. Asset turnover ratio Sales revenue = x times Average total assets Asset Efficiency Analysis • Asset turnover ratio • Shows an entity’s overall efficiency in generating income per dollar of investments in assets • Value will depend on the efficiency with which it manages its current and non-current investments • Higher means more efficient at making sales from assets

32. Days inventory Average inventory x 365 = x days Cost of sales Asset Efficiency Analysis (cont) • Days inventory and days debtors ratios • Days inventory ratio indicates the average period of time it takes to sell inventory • Lower is preferred as it indicates that inventory is being sold quickly

33. Days debtors Average accounts receivable x 365 = x days Sales revenue Asset Efficiency Analysis (cont) • Days debtors ratio indicates average period of time it takes to collect the money from its accounts receivable • Lower is preferred as it indicates that debtors are being collected quickly

34. Times inventory turnover Times debtors turnover Cost of sales = x times Average inventory Sales revenue = x times Average accounts receivable Asset Efficiency Analysis (cont) • It is common to calculate the number of times per year that all inventory is sold (times inventory turnover) and accounts receivable are collected(times debtors turnover), rather than the number of days this takes on average

35. Asset Efficiency Analysis (cont) • Days inventory and days debtors turnovers can be considered together to reflect the entity’s activity cycle (also referred to as the operating cycle) • A period of time (cash cycle) elapses between an entity paying for the inventory, selling the inventory, and receiving cash for the inventory

36. Asset Efficiency Analysis (cont)

37. Liquidity Analysis • The survival of the entity depends on its ability to pay its debts when they fall due (its liquidity) • An entity must have sufficient working capital (current assets)to satisfy its short-term requirements and obligations (current liabilities) • But excess working capital is undesirable because the funds could be invested in other assets that would generate higher returns (for example holding high levels of inventory is not good as the money could be invested in more profitable assets)

38. Current ratio Current assets = x times Current liabilities Liquidity Analysis (cont) • Current ratio and quick ratio • Current ratio (or working capital ratio) indicates $ of current assets per $ of current liabilities • Higher is preferred, but too high indicates excessive investment in current assets which may not be the most profitable

39. Quick asset ratio Current assets – inventory = x times Current liabilities Liquidity Analysis (cont) • Quick asset ratio (or acid test ratio) measures $ of current assets available (excluding inventory) to service each $ of current liabilities • Higher is preferred, but again too high is not desirable

40. Liquidity Analysis (cont)

41. Capital Structure Analysis • An entity’s capital structure is the proportion of debt financing relative to equity financing, and reflects the entity’s financing decision • Investments in assets are funded externally by liabilities, or internally by owner’s equity as shown in accounting equation: ASSETS = LIABILITIES + EQUITY

42. Debt ratio Equity ratio Debt to equity ratio Total liabilitiesx 100 = x% Total assets Total equityx 100 = x% Total assets Total liabilities x 100 = x% Total equity Capital Structure Ratios • Only 1 of the 3 capital structure ratios needs to be calculated, as all indicate use of debt relative to equity to finance investments in assets Prepared by Simon LenthenUniversity of Western Sydney

43. Interest coverage ratio EBIT = x times Net finance costs Capital Structure Ratios (cont) • Interest servicing ratios • The financial risk of the entity can also be assessed through the interest coverage ratio (also referred to as times interest earned) • Note: finance costs refer to interest expense • Higher is better, it means profit more comfortably covers interest costs

44. Debt coverage ratio Non-current liabilities = x times Net cash flows provided by operating activities Capital Structure Ratios (cont) • Debt coverage ratio • Debt needs to be serviced from cash flow, so it is useful to relate the entity’s cash generating capacity to its long-term debt • This ratio links cash flows from operating activities with long-term debt

45. Capital Structure Ratios (cont)

46. Net tangible asset backing per share Ordinary shareholders’ equity – Intangible assets = x cents/share No. of ordinary shares on issue at year-end Market Performance Analysis • Net tangible asset backing per share (NTAB) • Provides an indication of the book value of the entity’s tangible assets (as reported in the balance sheet) per ordinary share on issue • Intangible assets, such as goodwill, are excluded from calculation due to their lack of identifiability

47. Operating cash flow per share Dividend per share Earnings per share Net cash flows from operating activities – Preference dividends = x cents/shareWeighted no. of ordinary shares on issue Dividends paid to ordinary shareholders in current period = x cents/share Weighted no. of ordinary shares on issue Profit available to ordinary shareholders = x cents/share Weighted no. of ordinary shares on issue Market Performance Analysis(cont) • Earnings, cash flow and dividend per share

48. Price earnings ratio Current market price = x times Earnings per share Market Performance Analysis(cont) • Price earnings ratio (PER) • A market value indicator that reflects the number of years of earnings that investors are prepared to pay to acquire a share at its current market price

49. Dividend payout ratio Dividend per share x 100 = x% Earnings per share Market Performance Analysis(cont) • Dividend payout ratio • A market value indicator that reflects the proportion of current year’s profits that are distributed as dividends to shareholders

50. Market Performance Analysis(cont)