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Analysis of Financial Statements

Analysis of Financial Statements. Chapter 5. Sep 10, 2012. Learning Objectives. How financial ratio analysis helps managers assess the firm’s health. Compute profitability, liquidity, debt, asset activity, and market value ratios.

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Analysis of Financial Statements

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  1. Analysis of Financial Statements Chapter 5 Sep 10, 2012

  2. Learning Objectives • How financial ratio analysis helps managers assess the firm’s health. • Compute profitability, liquidity, debt, asset activity, and market value ratios. • Compare financial information over time and among companies – trends and comparisons

  3. Ratio Analysis • Financial managers use ratios to interpret the raw numbers on financial statements. • Relative measures allow comparison over time and to other firms (industry stds). • Ratios are used by financial managers, other business managers, creditors, and investors.

  4. Ratio Analysis • Profitability ratios • Liquidity ratios • Debt ratios • Asset activity ratios • Market value ratios Five Categories of Ratios

  5. Ratio Analysis • Measure the overall effectiveness of the firm’s management. • Did management’s decisions result in satisfactory returns to the owners i.e. Facebook Profitability Ratios

  6. Gross Profit Sales Gross Profit Margin = Ratio Analysis Profitability Ratios How effective is the firm at generating revenue in excess of its cost to manufacture it’s products. Rule of Thumb (ROT) = 40%

  7. Gross Profit = Margin Gross Profit Sales $575 $1,450 Gross Profit Margin = = 39.7% Balance Sheet Excalibur Corporation Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625Current Liabilities $230 Current Assets $1,230 Bonds $600 Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800 Total Owners’ Equity $1,700 Total Liabilities and Owners Equity $2,530 Income Statement Excalibur Corporation Sales $1,450 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Net Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40%) 108 Net Income $162

  8. Operating Income Sales Operating Profit Margin = Ratio Analysis Profitability Ratios How effective is the firm in keeping costs of research, marketing and administration under control? ROT = 20%

  9. Operating Profit = Margin Operating Income Sales $330 $1,450 Oper. Profit Margin = = 22.8% Balance Sheet Excalibur Corporation Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625 Current Liabilities $230 Current Assets $1,230 Long-term Debt $600 Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800 Total Owners’ Equity $1,700 Total Liabilities and Owners Equity $2,530 Income Statement Excalibur Corporation Sales $1,450 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40%) 108 Net Income $162

  10. Net Income Sales Net Profit Margin = Ratio Analysis Profitability Ratios How much profit (after tax) is being generated from each dollar of sales? ROT = 10%

  11. Net Profit = Margin Net Income Sales $162 $1,450 Net Profit Margin = = 11.2% Balance Sheet Excalibur Corporation Assets Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625 Current Liabilities $230 Current Assets $1,230 Long-term Debt $600 Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800 Total Owners’ Equity $1,700 Total Liabilities and Owners Equity $2,530 Income Statement Excalibur Corporation Sales $1,450 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40%) 108 Net Income $162

  12. Net Income Total Assets Return on Assets = Ratio Analysis Profitability Ratios How effectively is the firm generating net income from its assets ? ROT = 10%

  13. Net Income Total Assets Return on Assets = $162 $2,530 = 6.4% ROA = Balance Sheet Excalibur Corporation Assets Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625 Current Liabilities $230 Current Assets $1,230 Long-term debt $600 Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800 Total Owners’ Equity $1,700 Total Liabilities and Owners Equity $2,530 Income Statement Excalibur Corporation Sales $1,450 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40) 108 Net Income% $162

  14. Net Income Common Equity Return on Equity = Ratio Analysis Profitability Ratios How well is the firm generating return (income) to its equity providers (owners)? ROT = 15%

  15. Net Income Common Equity Return on Equity = $162 $1,700 ROE = = 9.53% Balance Sheet Excalibur Corporation Assets Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625 Current Liabilities $230 Current Assets $1,230 Long-term Debt $600 Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800 Total Owners’ Equity $1,700 Total Liabilities and Owners Equity $2,530 Income Statement Excalibur Corporation Sales $1,450 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40%) 108 Net Income $162

  16. Current Assets Current Liabilities Current Ratio = Ratio Analysis Liquidity Ratios • Measure the ability of the firm to meet its short-term financial obligations. Are there sufficient current assets to pay off current liabilities? What is the cushion of safety? ROT = 2.0x

  17. Current Assets Current Liabilities Current Ratio = $1,230 $230 Current Ratio = = 5.35x Balance Sheet Excalibur Corporation Assets Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625Current Liabilities $230 Current Assets $1,230 Long-term Debt $600 Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800 Total Owners’ Equity $1,700 Total Liabilities and Owners Equity $2,530 (Too big?)

  18. Current Assets - Inventory Current Liabilities Acid-Test Ratio = Ratio Analysis Liquidity Ratios • Measure the ability of the firm to meet its short-term financial obligations. Is the firm still able to repay current liabilities after what is usually the least liquid of the current assets (Inventory) is subtracted? ROT = 1.5x

  19. Current Assets - Inventory Current Liabilities Acid-Test Ratio = $1,230 -$625 $230 Acid-Test Ratio = = 2.63x Balance Sheet Excalibur Corporation Assets Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625Current Liabilities $230 Current Assets $1,230 Long-term Debt $600 Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800 Total Owners’ Equity $1,700 Total Liabilities and Owners Equity $2,530

  20. Ratio Analysis • Measure the relative size of the firm’s debt load and the firm’s ability to pay off the debt. Debt Ratios

  21. Total Debt Total Assets Debt Ratio = Ratio Analysis Debt Ratios What proportion of the firm’s assets is financed with debt (short term plus long term)? ROT = < 50%

  22. Total Debt Total Assets Debt Ratio = $230 + $600 $2,530 Debt Ratio = = 33% Balance Sheet Excalibur Corporation Assets Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625Current Liabilities $230 Current Assets $1,230 Long-term Debt $600 Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800 Total Owners’ Equity $1,700 Total Liabilities and Owners Equity $2,530 Income Statement Excalibur Corporation Sales $1,450 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40%) 108 Net Income $162

  23. Total Debt Common Equity Debt to Equity Ratio = Ratio Analysis Debt Ratios What is the proportion of debt financing relative to equity financing for the firm? ROT = < 1 to 1

  24. Debt to Equity Ratio Total Debt Common Equity = $230 + $600 $1,700 D/E = = .49 Balance Sheet Excalibur Corporation Assets Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625Current Liabilities $230 Current Assets $1,230 Long-term Debt $600 Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800 Total Owners’ Equity $1,700 Total Liabilities and Owners Equity $2,530 Income Statement Excalibur Corporation Sales $1,450 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40%) 108 Net Income $162 (Or, 0.49 to 1)

  25. Operating Income Interest Expense Times Interest Earned Ratio = Ratio Analysis Debt Ratios What is the firm’s ability to repay interest payments from its operating income? ROT = 7x

  26. Times Interest = Earned Ratio Operating Income Interest Expense $330 $60 TIE Ratio = = 5.50x Balance Sheet Excalibur Corporation Assets Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625Current Liabilities $230 Current Assets $1,230 Long-term Debt $600 Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800 Total Owners’ Equity $1,700 Total Liabilities and Owners Equity $2,530 Income Statement Excalibur Corporation Sales $1,450 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40%) 108 Net Income $162

  27. Ratio Analysis • Help assess how effectively the firm is using assets to generate sales. Asset Activity Ratios

  28. Accounts Receivable Avg. Daily Credit Sales Average Collection Period = Ratio Analysis Asset Activity Ratios How long does it take for the firm on average to collect its credit sales from customers? ROT = 45 to 60 days

  29. Average Collection = Period Accounts Receivable Avg. Daily Credit Sales $430 $1,450/365 ACP = = 430 3.97 Balance Sheet Excalibur Corporation Additional Info: We assume all sales are credit sales. Assets Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625Current Liabilities $230 Current Assets $1,230 Bonds $600 Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800 Total Owners’ Equity $1,700 Total Liabilities and Owners Equity $2,530 Income Statement Excalibur Corporation Sales $1,450 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40%) 108 Net Income $162 = 108 days! Days in a year

  30. Cost of Goods Sold Inventory Inventory Turnover Ratio = Ratio Analysis Asset Activity Ratios How frequently is inventory being converted into product for sale? ROT = 3 to 4x JIT = 12 to 15x

  31. Inventory Turnover = Ratio COGS Inventory $875 $625 Inventory Turnover = = 1.4x Balance Sheet Excalibur Corporation Assets Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625Current Liabilities $230 Current Assets $1,230 Long-term Debt $600 Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800 Total Owners’ Equity $1,700 Total Liabilities and Owners Equity $2,530 Income Statement Excalibur Corporation Sales $1,450 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40%) 108 Net Income $162

  32. Sales Net Fixed Assets Fixed Asset Turnover Ratio = Ratio Analysis Asset Activity Ratios How effective is the firm in using its fixed assets to help generate sales? ROT = 1.5x

  33. Fixed Asset Turnover = Ratio Sales Net Fixed Assets $1,450 $1,300 Fixed Asset Turnover = = 1.12x Balance Sheet Excalibur Corporation Assets Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625Current Liabilities $230 Current Assets $1,230 Long-term Debt $600 Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800 Total Owners’ Equity $1,700 Total Liabilities and Owners Equity $2,530 Income Statement Excalibur Corporation Sales $1,450 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40%) 108 Net Income $162

  34. Sales Total Assets Total Asset Turnover Ratio = Ratio Analysis Asset Activity Ratios How effective is the firm in using its overall assets to generate sales? ROT = > 1.0x

  35. Total Asset Turnover = Ratio Sales Total Assets $1,450 $2,530 Total Asset Turnover = = 0.57x Balance Sheet Excalibur Corporation Assets Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625Current Liabilities $230 Current Assets $1,230 Long-term Debt $600 Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800 Total Owners’ Equity $1,700 Total Liabilities and Owners Equity $2,530 Income Statement Excalibur Corporation Sales $1,450 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40%) 108 Net Income $162

  36. Market Price per Share Earnings per Share Price to Earnings Ratio = Ratio Analysis Market Value Ratios How much are investors willing to pay per dollar of earnings of the firm? (Indicator of investor’s attitudes toward future prospects of the firm and of the firm’s risk.) ROT = 15 to 20 x earnings

  37. P/E Ratio Market Price/Share EPS = $20.00 $162/100 P/E ratio = = 12.35x Balance Sheet Excalibur Corporation Additional Info: 100 shares $20.00 per share Assets Liabilities Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625Current Liabilities $230 Current Assets $1,230 Long-term Debt $600 Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800 Total Owners’ Equity $1,700 Total Liabilities and Owners Equity $2,530 Income Statement Excalibur Corporation Sales $1,450 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40%) 108 Net Income $162

  38. Market Price per Share Book Value per Share Market to Book Ratio = Ratio Analysis Market Value Ratios How much are investors willing to pay per dollar of book value? How much value has management added to the firm above the value of the assets. (No ROT, but say at least 2x)

  39. Market to = Book Price/Share Common Equity/ # shares $20.00 $1,700/100 M/B = = 1.18x Balance Sheet Excalibur Corporation Assets Liabilities Additional Info: 100 shares $20.00 per share Cash $175 Accounts Payable $115 Accounts Receivable 430 S-T Notes Payable 115 Inventories 625Current Liabilities $230 Current Assets $1,230 Long-term Debt $600 Plant & Equipment $2,500 Owner’s Equity Less:Acc. Depr. (1,200) Common Stock $300 Net Fixed Assets $1,300 Capital in Excess of Par 600 Total Assets $2,530 Retained Earnings 800 Total Owners’ Equity $1,700 Total Liabilities and Owners Equity $2,530 Income Statement Excalibur Corporation Sales $1,450 Cost of Goods Sold 875 Gross Profit $575 Operating Expenses 45 Depreciation 200 Operating Income $330 Interest Expense 60 Income Before Taxes $270 Taxes (40%) 108 Net Income $162

  40. Ratio Industry Excalibur Profitability Gross Profit Margin 38% 39.7% Operating Profit Margin 20% 22.8% Net Profit Margin 12% 11.2% Return on Assets 9.0% 6.4% Return on Equity 13.4% 9.5% Excalibur is good at keeping operating costs down. ROA and ROE are very low mainly due to low sales, productivity and asset management problems.

  41. Summary of Excalibur Corporation Ratios Ratio Industry Excalibur Liquidity Current Ratio 5.00x 5.35x Acid-Test Ratio 3.00x 2.63x Looking at the current ratio it appears that Excalibur is more liquid than the industry.... however when looking at Acid Test (a better measure) they are not as liquid indicating that inventory levels are probably too high. Relative to ROT, accounts receivable too high as well.

  42. Ratio Industry Excalibur Debt Debt Ratio 35% 33% Times Interest Earned 7.00x 5.50x Debt to Equity 49% 48% While the debt ratio is close to the industry average, Excalibur is not able to cover interest payments as easily as the industry. This indicates Excalibur may have too much debt relative to what they can realistically afford.

  43. Ratio Industry Excalibur Asset Activity Avg. Collection Period 60 days 108 days Inventory Turnover 3.00x 1.40x Fixed Asset Turnover 1.00x 1.12x Total Asset Turnover 0.75x .57x Collection policies need examining, as Excalibur is much slower than average at collecting receivables. Inventories are being sold much more slowly than the industry average, again indicating inventories that are too high. Excalibur is more efficient at converting Fixed Assets to Sales (fixed assets are productive). However, overall assets are not productive indicating Current Assets (e.g. inventories and receivables) are not as productive as for the industry.

  44. Ratio Industry Excalibur Market Value Price Earnings 18.0 12.35 Market to Book 2.5 1.18 Excalibur’s Investors are not willing to pay as much per dollar of earnings or per dollar of book value as they are for shares in other firms in the industry. This signals that they consider the firm’s prospects to be worse than the average. However, the firm is still selling for more than its accounting book value.

  45. Industry Comparisons • Industry standards • Rule of thumb • Best in class (NSC) • See table 5-3, page 113

  46. Trend Analysis • Trends tell you which way the company is headed with respect to its financial condition • This is a must part of any financial statement analysis • See table 5-1, and 5-3

  47. Sources of Financial Information • Many organizations publish financial information about companies and industries • Some are free, or require a fee (but check the MLK library) • See table 5-4 for sources of information

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