Chapter 5 Financial Statement Analysis

1. Chapter 5Financial Statement Analysis

2. Three Approaches to Financial Statement Analysis • Horizontal analysis • Vertical analysis • Ratio analysis

3. Horizontal Analysis Compares two financial statements Shows dollar and percentage differences When reviewing financial statements focus on significant differences!

4. Vertical Analysis • Financial statements reduced to percentages • Balance sheet: • Assets = 100% • Liabilities & OE = 100% • Income statement: net revenue = 100%

5. Which company has the best performance? Why?

6. Ratio Analysis • Comparing two related numbers from financial statements • Expressed as $, %, times, days, etc. • Purposes for managers: • Express goals for business • Track performance of the operation • Communicate financial performance • Result must be compared to a standard

7. Standards • Budget • Prior period • Industry average

8. Classes of Ratios • Liquidity – can the firm meet its short-term obligations? • Solvency – can the firm meet its long-term obligations? • Activity – how is management using the property’s assets? • Profitability – how profitable is the business? • Operating – how efficient is management in running the business?

9. Liquidity Ratios • Current Ratio – indicates relationship between current assets and current liabilities • Formula: CR = Current Assets/Current Liabilities

10. Acid-Test Ratio • Acid-Test Ratio: • A more stringent measure than the CR as inventories and prepaid expenses are excluded

11. Accounts Receivable Turnover • This ratio shows the number of times the average accounts receivable have been collected. • AR T/O: Total revenue/Average accounts receivable • Note: When comparing figures from a stock statement (balance sheet) and a flow statement (income statement) use an average for the figures from the balance sheet!

12. Average Collection Period (ACP) • ACP is another to view the collection of AR • ACP = 365/AR T/O • Expresses average number of days receivables are outstanding

13. Operating Cash Flows to Current Liabilities Ratio • Purpose of ratio is compare operating cash flows to current debt. (Cash pays the bills, not CA!) • OCF to CL Ratio = OCF/Average CL

14. Liquidity Evaluation Illustration Selected liquidity ratios for AW Corporation are as follows: Evaluate the change in liquidity for AW corporation

15. Evaluation The current and acid-test ratios are increasing throughout the 2008-2010 period. The AR T/O is decreasing resulting in relatively more accounts receivable outstanding. ACP was 30.4 days at the end of 2008 and increased to 36.5 days at the end of 2010. This increase should be further investigated. Operating cash flows are increasing overtime in relation to the current obligations. Overall liquidity is improving; however, there is some concern regarding accounts receivable.

16. Solvency Ratios • Two major perspectives – balance sheet and income statement • Balance sheet • Debt-equity • LTD to total capitalization • Income statement • Number of times interest earned (TIE) • Fixed charge coverage • SCF: OCF to total liabilities ratio

17. Debt-Equity Ratio • Shows amount of debt for each $1 of owner’s equity • DE Ratio: total liabilities/total owners’ equity

18. Long-Term Debt to Total Capitalization Ratio • Total capitalization = LTD + Owners’ Equity • Shows LTD as % of total capitalization • LTD to Total Cap. Ratio = LTD/LTD + OE

19. Number of Times Interest Earned (TIE) • Indicates the number of times interest can be covered with income • TIE = EBIT/Interest Expense

20. Fixed Charge Coverage Ratio • Lease expense is added to the numerator and denominator of the TIE ratio • FCC Ratio = (EBIT + Lease Expense)/ (Interest + Lease Expense)

21. Operating Cash Flows to Total Liabilities Ratio • Uses figures from Balance Sheet and SCF • OCF to TL Ratio = OCF/Average TotalLiabilities

22. Solvency Evaluation Illustration BC, Inc., has solvency ratios for 2008 – 2010 as follows: Evaluate the changing solvency of BC, Inc. over the three years

23. Evaluation Both the debt-equity and LTD to total capitalization ratios reveal relatively less debt to equity over the three years. The increasing TIE and OCF to TL ratios suggest an increasing ability to pay the long-term liabilities. The decreasing fixed charge average ratio suggests lease expense (and most likely the number of leases) are increasing over time. Overall solvency has improved and in part this has happened by switching to leasing as a means of finance.

24. Activity Ratios • Inventory Turnover • Property and Equipment Turnover • Asset Turnover • Non-financial ratio: occupancy

25. Inventory Turnover • This ratio shows how quickly inventory is moving • A separate turnover should be determined for each type of inventory, i.e., food, beverage, gift shop etc.

26. Food Inventory Turnover • Food Inventory Turnover = • Cost of Food Used: BI + purchases – EI

27. Food Inventory Holding Period (FIHP) • Provides the average number of days inventory is held prior to sale • FIHP =

28. Property and Equipment Turnover (PET) • Measures management’s effectiveness in using property and equipment • PET =

29. Asset Turnover Ratio • Measures management’s use of all assets • Asset Turnover Ratio:

30. Paid Occupancy Percentage • A non-financial key indicator of management’s success in selling rooms • Paid occupancy % = • Rooms sold include all rooms occupied except for complimentary rooms • Rooms available include rooms that could be sold and generally exclude out-of-order rooms

31. Activity Evaluation Illustration The Dirk Company’s activity ratios over a three year period were as follows: How has management’s use of the company’s resources changed over the three year period?

32. Evaluation Food inventory is turning more quickly from 2008 through 2010 as is both property and equipment and total assets. This result is considered good. Paid occupancy is declining slightly. Management appears to be selling few rooms; however, the ADR (price per room) could be a major factor. This requires additional management attention.

33. Profitability Ratios • These ratios measure the overall effectiveness of management • Major ratios include: • Profit Margin • Operating Efficiency Ratio • Return on Assets • Return on Equity • EPS • PE Ratio

34. Profit Margin • Measures the profits from sales • Profit Margin =

35. Operating Efficiency Ratio • Measures management’s performance based on expenses they control • Operating Efficiency Ratio:

36. Return on Assets (ROA) • Indicator of profitability compared to the firm’s assets • ROA =

37. Return on Equity (ROE) • Measures profitability of firm compared to owners’ investment • ROE =

38. Earnings per Share (EPS) • Shows the amount earned per each share of owners’ common stock • EPS =

39. Price Earnings Ratio (PE) • Reflects the relationship between the market price per share and the EPS • PE =

40. Profitability Evaluation Illustration The Mellow Motel Corporation’s profitability ratios for 2008 through 2010 were as follows: Evaluate the corporation’s changing profitability over the three-year period.

41. Evaluation Profit margin is increasing each year even though the operating efficiency ratio is in decline. ROA, ROE, and EPS are increasing each year. This suggests that greater profits are being achieved by relative reductions in fixed charges such as interest expense and depreciation. The market appears to be reacting favorably to these changes since the PE ratio has increased from 10 times in 2008 to 12 times in 2010. The market price at the end of 2008 was $20 and at the end of 2010 it was $26.40.

42. Operating Ratios • Assist management in analyzing the operations of the business • Major ratios covered include • Average daily rate (ADR) • REVPAR • Food Cost Percentage • Labor Cost Percentage

43. Average Daily Rate (ADR) • Reveals average price per room sold • ADR =

44. REVPAR • Measures a combination of paid occupancy % and ADR • REVPAR = Paid OCC % X ADR

45. Food Cost Percentage • Key food service ratio that compares the cost of product (food) sold to product (food) sales • Food Cost % =

46. Labor Cost Percentage • Reveals the relationship between labor costs and revenue • Labor cost generally is the highest single cost of a hospitality organization • Labor costs include salaries, wages, fringe benefits, and payroll taxes • Ratio should be computed for each profit center of the operation

47. Labor Cost % • Labor Cost % =

48. Evaluation of Operations Illustration The Wisker Restaurant Inn has selected operating ratios for 2008-2010 as follows: Evaluate the operating activities of the Wisker Restaurant & Inn over the three-year period based on the above four ratios

49. Evaluation • First, one should be very careful when evaluating any aspect of business with so few ratios. Even so, these four ratios suggest • Prices are increasing but the amount per room available is decreasing from 2008 through 2010. This appears to suggest some price resistance and management should undertake further evaluation. • Both food cost and labor cost percentages are decreasing over the three year period. If quality is not sacrificed this is good from a financial perspective.

50. Limitations of Ratio Analysis • Only indicators • Must be based on two related numbers • Most useful when compared to a standard • Be careful when comparing financial ratios of different firms • Are they in the same industry? • Are they using the same or similar accounting procedures?