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Chapter 14

Chapter 14. Financial Statement Analysis. Who and Why?. To understand the economics of a firm and To help forecast its future profitability and risk Managers Responsible for day to day operations and long-r un performance

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Chapter 14

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  1. Chapter 14 Financial Statement Analysis

  2. Who and Why? • To understand the economics of a firm and • To help forecast its future profitability and risk • Managers • Responsible for day to day operations and long-run performance • Responsible and accountable for efficiency, effective deployment of capital, human resource and other resource management • Owners • Interested in current and long-term returns on their investments • Expect growing earnings, dividends • Affected by how earnings are distributed and how their shares are valued in the market • Lenders and creditors • Concerned about liquidity and cash flow of the company • Interested in the degree of financial leverage employed • Others: employees, government, society

  3. Financial Statement Analysis • Should start with an understanding of • Global and local macro economic condition • Industry (past performance, future expectations, competition etc…) • Should involve time series analysis, • Should compare performance with peers, competitors, industry averages

  4. Tools • Analytical Analysis • Vertical Analysis • Horizontal Analysis • Ratio Analysis

  5. Analytical Analysis • Vertical Analysis • Express the items in the financial statements as a percentage of total assets or sales

  6. Income Statement- Vertical Analysis

  7. Balance Sheet Vertical Analysis

  8. Analytical Analysis • Vertical Analysis • Express the items in the financial statements as a percentage of total assets or sales • Horizontal Analysis • A base year is selected and the changes overtime are expressed as percentage of the base year • Annual percentage changes are computed

  9. Ratio Analysis • Important point: to be selective-too many ratios would lead to information overload • Understand the meaning and limitations of the ratios • Define the following elements before starting: • The viewpoint taken • The objectives of the analysis • The potential standards of comparison

  10. Usefulness of Ratios • Help compare different firms, and • Help compare the firm against its past performance • Standards against which to compare ratios 1. The planned ratio for the period 2. The corresponding ratio from a prior period 3. The corresponding ratio for another firm in the same industry 4. The average ratio for other firms in the same industry

  11. Ratio Analysis Categories • Activity (operations and asset management) • Liquidity (meeting short-term obligations) • Solvency (meeting long-term obligations) • Profitability (earnings and cost coverage) • Cash Flow (quality of earnings) • Price Multiples (stock price)

  12. Activity Ratios • Receivable turnover • Average collection period

  13. Activity Ratios • Inventory turnover • Average days in inventory

  14. Activity Ratios • Payable Turnover • Average payment period

  15. Activity Ratios • Cash Cycle:

  16. Activity Ratios • PP&E Turnover • Asset Turnover

  17. Activity Ratios- Summary

  18. Liquidity Ratios • Current ratio • Ability to meet short-term obligations • [Current assets/current liabilities] • Quick ratio • Remove less liquid assets • Keep cash, liquid investments, A/R • [(Cash+short-term investments + A/R)/current liabilities]

  19. Liquidity Ratios

  20. Solvency Ratios • Debt to assets: Total liabilities/Total assets • Proportion of assets financed with debt • Could include interest bearing debt only [(short term debt + noncurrent debt)/total assets] • Be aware that assets are recorded at historical cost, which may be different from current market value

  21. Solvency Ratios • Debt to equity: Total liabilities/Total equity • A measure of how assets are financed

  22. Solvency RatiosCoverage Ratios • Adequacy of resources for meeting firm’s contractual obligations • Times interest earned • Can the firm cover its interest obligations? • (EBIT/Interest expense) • Cash interest coverage • (Cash from ops + interest paid + tax paid)/Interest paid

  23. Profitability Ratios • Gross Margin: profitability of sales • Return on Sales: Net profitability of the company

  24. Profitability Ratios • Retun on Assets • Return on Equity

  25. Profitability Ratios

  26. Cash Flow RatiosQuality of earnings • Ability to pay obligations • CFO/Total liabilities • CFO = Cash flows from operations • Profitability (cash flow relative to sales) • CFO/Sales revenue • Cash flow-earnings index • CFO/Net income

  27. Price Multiple Ratios • Market’s valuation of a firm’s common stock P/E = Share price/Earnings per share • Price/book ratio compares stock’s price to the recorded value of the net assets [Share price/(Book value of equity/Share outstanding)]

  28. Limitation of Ratio Analysis • Represent the average conditions and influenced by the accounting methods used • Based on historical data and do not reflect price level effects and real economic values • Changes in many ratios are strongly associated with each other and interrelationships among/between the ratios should be examined • During comparison of ratios over a period of time changes in operating conditions should be taken into consideration • During comparison between companies differences among the companies should be examined • Use audited financial statements to perform ratio analysis

  29. Analysis of Anadolu Cam • The changes in total assets and total liabilities over the period confirm the company’s investments that started in 2005. During the period the following changes in total assets and total sales were realized:

  30. After the realization of investments, profitability of the company showed a decline which caused fluctuations in net income. • The growth in total sales lagged behind the growth in total assets which is generally expected in times of investments. The efficiency of assets should be investigated by the help of turnover ratios in the ratio analysis. • The proportion of total current assets to current liabilities has been changing in favor of current liabilities which require further analysis for short term liquidity. • Long-term assets are mainly funded by shareholders’ equity and long-term liabilities which is preferable for long-term solvency. However, the composition of long-term funds is changing over the years in favor of the liabilities. • The composition of total assets didn’t change a lot over the years presented, although there are slight changes within the composition of current assets. This requires further investigation in ratio analysis.

  31. Activity Ratios • All activity ratios for operating items have been decreasing. Both accounts receivable and inventory turnover ratios decreased considerably after 2005 (after the investment): This may be a result of higher working capital requirements of the new investment, or a general trend in the industry. Furthermore, accounts payable turnover increased in 2007 although no improvements are observed for receivables and inventories. These are expected to increase the need of working capital requirements of the company. In other words, the increase in cash cycle to 89 days requires additional funding for the company. When the increase in financial liabilities from 2005 to 2006 is considered (90%), one can conclude that the company financed the working capital investments by short term financial liabilities. • The decreases in turnover rates for accounts receivable and inventories and the increase in the accounts payable turnover is a future threat for the short term liquidity of the company.

  32. Activity Ratios • The performance in the PPE and total asset turnover is as expected. After the investments PPE turnover together with the total asset turnover declined (for 2005 and 2006). Such turnover rates improved in 2007 when the investments were completed.

  33. Short term Liquidity • Short-term liquidity ratios of the company had been decreasing since 2005. This may be a result of making investments. Both the current and the quick ratios are below the rule of thumb ratios of 2 and 1, respectively. • There is a considerable difference between the current and the quick ratio. This is normally an indication of inventory dependence. When one checks the level of inventories and the increase in inventories, it seems that inventory account has been growing. As the inventory turnover of the company is decreasing over the years, we can conclude that short term liquidity of the company is alarming. As of the last reporting date, it seems that the company may not be able to pay its current liabilities with its most quick assets. In addition, because of the decreases in inventory, current assets may also not be sufficient to meet the current liabilities.

  34. Long-term Solvency • Both the debt ratio and the debt to equity ratio are at the acceptable levels. Under normal conditions debt ratio of 50% is deemed to be optimal for the financial risk of the company. • The debt ratio started to increase in 2005 after the investments. This means that the company financed its investments by using liabilities. Since these liabilities are long-term, they shouldn’t adversely affect the risk. Also, by using liability funding the company is expected to enjoy financial leverage. As of the end of the last reporting period, the company doesn’t seem to have a long-term solvency problem. It has a healthy financial structure. • Times interest earned is used by creditors to assess the ability to make interest payments from the earnings of the company. Until 2006, interest coverage performance of the company was very successful. However, starting with 2006, both the short term and long term financial liabilities increased, and so the financial expenses. In addition in 2006, as will be explained in the profitability analysis, operating income of the company declined significantly. All the above mentioned factors caused times interest earned ratio to decline. However, we should also note that the ratio recovered in 2007 as a result of recovery in profitability. Although it would better to have a higher coverage ratio, we believe the current performance of the company does not raise a red flag at the moment.

  35. Profitability • To assess the company’s performance in terms of profitability we should also use the ratios of a similar company as we should for the activity ratios. • Over the years the company’s profitability declined until 2007. Especially in 2006 both the operating margin and the net profit margin had declined significantly. One of the reasons of such decrease could be the increase in fixed costs of the company after making the investment. When one analyses the income statement and the related notes to the financial statements there are three important reasons for the decreasing profits of 2006: • Within the operating expenses, selling expenses increased a lot, which may be due to marketing efforts after the capacity increase. These expenses declined in the following year. • Secondly, the company had approximately YTL19.000 of losses from sale of property, plant and equipment. In 2006 after the new investment, the company might have disposed of old equipment. Losses on sales of PPE are not continuing expenses therefore; they are not expected to adversely affect profitability in the future. • The third reason of the decrease in profitability in 2006 is the 170% increase in the financial expenses as a result of the increase in the borrowings during the same period. Financial expenses continue to increase in 2007, however, as total sales also increased, percent of financial expenses within sales is constant. • The company’s ROE and ROA had sharp decreases in 2006. Such a sharp decrease in that year had two reasons: First because of the reasons explained above, net income decreased. Second is the growth in assets and shareholders’ equity. The decrease in ROA is sharper because of the increase in the assets. Both ratios recovered back in 2007, although they didn’t reach their previous levels. • In summary, although the company’s profitability ratios declined after the investment, improvements had started in 2007. If the sales of the company continue to increase, profitability performance of the company doesn’t raise any red flags.

  36. Cash Flow Performance • The company had been generating positive operating cash flows for the last four years, and the cash flow index is more than 2 over the same period. Therefore there doesn’t seem to be a earnings quality problem. • During 2006 the company had positive cash flows from operating and financing activities. Investments were mostly financed by liabilities. In 2007 cash flows from financing activities was also negative. The company started to pay back the liabilities. It also continued to pay dividends, although not as much as the previous year.

  37. Market Ratios • Price earnings ratio of the company was considerably high in 2006, which was probably due to lower earnings at that year. It declined in 2007 for two reasons: First the earnings increased, second share price declined. We should check the PE ratios and the market performance of other companies as well to comment on the decrease of the share price. • However, the fact that the company increased its share capital by issuing free shares from the inflation adjustment might have caused the share price to decrease.

  38. Conclusion • Except for the short term liquidity, the company’s financial position and performance is satisfactory. However before making any concluding remarks, we should also compare the results of this analysis with industry averages and/or a similar company. • Future success of the company is dependent on the continuing increase in the growth of sales revenues. 2009 is a period for which growth in the economy and in many other industries is not very promising, therefore the company may face difficulties in increasing its sales. And if the sales do not increase as expected the company’s future earnings may be at stake. Furthermore, the company’s short term liquidity is currently dependent on sustainable short term bank loans. If banks call back the loans and/or don’t give additional loans, the company may not be able to pay back its liabilities. • One more point to be considered is the group within which the company operates. It’s a part of Şişecam which is owned by İşbank. Its shareholders are currently very powerful in the market. Furthermore, the company is the largest in its area. One adverse point about the future of the company, is the fact that its second market is Russia, where the economy is not going very well.

  39. Recommendations • It is not advisable to provide a short term loan for the company. However, from the perspective of a current short term creditor, calling back the loan also doesn’t seem to be a good choice, as loans may not be ultimately paid back if called early. For a new creditor it wouldn’t be wise to give a new short term loan. • The company’s financial structure is sound. It generates profits and operating cash flows. Therefore, a long-term loan may be provided. • As an investor, ignoring the current market conditions, Anadolu Cam may be a good investment alternative. The company is profitable and paying dividends. Furthermore, its PE ratio has declined in the previous year. It can be expected to increase in the future. However, if the stock market is expected to decline due to general economic conditions, investing in a stock may not be a good idea from a short-term perspective. If the investor has long-term investment goals, Anadolu Cam shares may be purchased.

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