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FINANCIAL STATEMENT ANALYSIS

CHAPTER 5. FINANCIAL STATEMENT ANALYSIS. Financial Statement Analysis. Annual reports Auditor’s report Director’s report Statement of Financial Performance (Income statement) Statement of Financial Position (Balance sheet) Cash flow statement.

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FINANCIAL STATEMENT ANALYSIS

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  1. CHAPTER 5 FINANCIAL STATEMENT ANALYSIS

  2. Financial Statement Analysis • Annual reports • Auditor’s report • Director’s report • Statement of Financial Performance (Income statement) • Statement of Financial Position (Balance sheet) • Cash flow statement

  3. Objectives of Financial Statement Analysis • Equity investors • Return on capital • Capital preservation • Credit grantors • Short-term – interest cover • Long-term – interest cover and capital preservation • Management • Decision making • Control

  4. Objectives of Financial Statement Analysis • Employees • Job security • Wage & salary negotiations • Acquisition and merger analysts • Valuation of potential candidates • Auditors • Analytical review • Other/Tax authorities • Income fairly stated

  5. Statement of Comprehensive Income & Statement of Changes in Equity

  6. Statement of Financial Position

  7. Statement of Cash Flows

  8. Approaches • Comparative trend analysis • Index analysis • Common size analysis • Ratio analysis • Economic Value Added (EVA)

  9. Approaches continued… • Comparative financial statements: • Direct comparison of current statements to numerous prior year statements to detect any trends. • Index analysis: • Similar to comparative method, but a base year is used to express values as percentages for succinct comparisons.

  10. Index analysis • The percentages provide a more relatable comparison

  11. Common Size Analysis • Statement of Comprehensive Income • All line items are expressed as a percentage of Sales Revenue

  12. Application of Ratio Analysis • Liquidity ratios • Current ratio • Quick ratio • Asset management ratios • Stock (inventory) turnover • Average collection period • Fixed asset turnover • Total asset turnover

  13. Application of Ratio Analysis • Debt management ratios • Debt ratio • Times interest earned • Debt equity ratio • Profitability ratios • Gross profit margin • Profit margin • Return on total assets • EBIT • EBIAT • Net profit

  14. Application of Ratio Analysis • Cash flow ratios • Cash flow to total debt • Market value ratios • Dividend yield • Earning yield • Price earnings ratio • Dividend cover

  15. Liquidity Ratios • Current Ratio current assets/current liabilities • Typical Ltd: 208/120 = 1.73 • Quick ratio (or acid test ratio) (current assets-inventory)/current liabilities • Typical Ltd: (208-65)/120 = 1.19

  16. Asset Management Ratios • Stock (inventory) turnover • Cost of sales / inventory (or sales / inventory) • Typical Ltd: 2036/65 = 31.3 times • Average collection period • Accounts receivable/(sales/365) • Typical Ltd: 122/(3573/365) = 12.46 days • Fixed asset turnover • Sales/fixed assets • Typical Ltd: 3573/1227 = 2.91 times • Total asset turnover • Sales/operating assets • Typical Ltd: 3576/(1227 + 208) = 2.49 times

  17. Debt Management Ratios • Debt Ratio • Debt ratio = total debt/total assets • Typical Ltd: (400+120)/(1227+208) = 36.24% • Times Interest Earned (TIE) • TIE = EBIT/interest • Typical Ltd: 282/100 = 2.82 times • Debt/Equity Ratio • Debt equity = total debt/total equity • Typical Ltd: (400+120)/915 = 56.83%

  18. Profitability Ratios • Gross Profit Margin • GP% = gross profit/sales • Typical Ltd: 1537/3573 = 43% • Net Profit Margin • NP% = net profit /sales • Typical Ltd: 282/3573 = 7.89%

  19. Profitability Ratios continued... • Return on Assets (NB) • ROA = EBIT/Assets • Typical Ltd: 282/(1227 + 208) = 19.65% • ROA = EBIAT/Assets • Typical Ltd: (128 + (100x0.72)/(1227 + 208) = 13.94% • ROA = Net profit/Assets • Typical Ltd: 128/(1227 + 208) = 8.92% • Return on Equity (NB) • ROE = Net income / total shareholders’ funds • Typical Ltd: 128/915 = 13.99%

  20. Cash Flow Ratios • Cash flow to total debt Cash flow from operations/total debt • Typical Ltd: 219/520 = 42.12% • What does this mean?

  21. Market Value Ratios • Dividend Yield Dividend per share / share price • Typical Ltd: 10.6/280 = 3.79% • Earnings Yield Earnings per share / share price • Typical Ltd: 25.6/280 = 9.14% • Price-Earnings Ratio Share price / earnings per share • Typical Ltd: 280/25.6 = 10.94

  22. Market Value Ratios continued... • Dividend Cover Earnings per share / dividend per share • Typical Ltd: 25.6 / 10.6 = 2.42 times • Market to Book Ratio Share price / NAV per share

  23. Du Pont Analysis • Du Pont model • ROA = Net profit margin x total asset turnover • Modified Du Pont model • ROE = ROA x financial leverage multiplier ROE = {(earnings/total assets) x (total assets/equity)} • Impact of income • Impact of activity • Impact of capital structure

  24. Du Pont Analysis • From Net profit margin to ROE: • Notice how the “sales” and “assets” items cancel each other out to leave you with: NET PROFIT / EQUITY • What is this ratio called?

  25. Failure Prediction • Altman’s model – based on NYSE failures • De la Rey’s model – based on JSE failures • Limitations of MDA (statistical) models • Not industry specific • Presume no fundamental changes over time • Zone of uncertainty exists • Altman’s Z” found to be valid for SA companies

  26. Limitations of Ratio Analysis • Using industry averages as a benchmark • Non standard accounting policies • Non standard year-ends • Creative accounting • Subjective assessment • The impact of inflation • ROA may be artificially inflated

  27. EVA • Economic value added is used for performance measurement • Value is created by • Improving the return on existing assets • Investing in new assets with a return > WACC • Selling assets with a return < WACC • Reducing the WACC • See use of EVA at SABMiller example in book • EVA = NOPAT – (c x capital) • The PV of expected future EVAs is the MVA

  28. Behind the Numbers • Understand the business and the industry sector • What are the company’s strategies? • Why did Warren Buffet invest in Gillette? • Understand management’s motives for selecting accounting policies • Loan covenants • Management incentives • Taxation • Regulatory issues

  29. Behind the Numbers continued… • Understand the key drivers of value • Certain ratios are critical to a specific industry • For example: Operating margin in retail • Understand which accounting policies are flexible • Accounting for leases • Operating versus finance leases • Off-balance sheet financing

  30. Behind the Numbers continued… • Understand the Warning Signs! • Increase in accounts receivable that exceeds the increase in sales • Increase in inventory that exceeds the increase in sales • Restructuring, non-recurring charges and asset write-downs or sales • Accounting income and tax losses • Accounting income and a negative operating cashflow • Complex company structures and related party transactions • Accounting policies in relation to research and development, depreciation and leasing

  31. Behind the Numbers continued… • Accounting policies that differ from the industry norm • Lack of corporate governance • Changes in auditors, qualified opinions or published disagreements with the auditor • Understand the business and financial risks facing the company • Micro and macro factors

  32. Additional Factors to Consider When Analysing a Company • Are the directors selling their shares in the company? • Is the company aggressive in recognising revenue in relation to long-term contracts? • Is the company aggressive about acquisitions? • Are the company’s customers performing well? • Is the company under litigation? • Is the company subject to significant operational risks? Does the company have insurance to cover such risks?

  33. Additional Factors to Consider When Analysing a Company • Does the company have actual or potential environmental liabilities? (E.g. mining companies) • Are there reports of problems with product quality? • Does the company have strong brands? • Does the company communicate well with its shareholders and analysts? • Is management incentivised to focus on shareholder interests? • Is the quality of management superior to other companies in the sector? • Does the company make optimal use of Information Technology? • Does the company have valuable intangible assets?

  34. Sustainable Growth Rate SGR = D/E {R – i}p + {R}p Where: D = Total debt E = Total equity R = ROI = {EBIAT / TA} i = Average after tax cost of borrowing p = Percentage of earnings retained

  35. Sustainable Growth Rate

  36. Ratios for South AfricaSource: ABSA

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