Financial Statement Analysis

Mary Low
Waikato Management School
The University of Waikato

© Mary Low
 Business Survival:
There are two key factors for business survival:
• Profitability
• Solvency

• Profitability is important if the business is to

generate revenue (income) in excess of the
expenses incurred in operating that business.
• The solvency of a business is important
because it looks at the ability of the business in
meeting its financial obligations.

© Mary Low
 Financial Statement Analysis
• Financial Statement Analysis will help business
owners and other interested people to analyse
the data in financial statements to provide them
with better information about such key factors for
decision making and ultimate business survival.

© Mary Low
 Financial Statement Analysis
Purpose:
• To use financial statements to evaluate an
organisation’s
– Financial performance
– Financial position.
• To have a means of comparative analysis across time
in terms of:
– Intracompany basis (within the company itself)
– Intercompany basis (between companies)
– Industry Averages (against that particular industry’s averages)
• To apply analytical tools and techniques to financial
statements to obtain useful information to aid decision
making.

© Mary Low
 Financial Statement Analysis
Financial statement analysis involves analysing the
information provided in the financial statements to:
– Provide information about the organisation’s:
• Past performance
• Present condition
• Future performance
– Assess the organisation’s:
• Earnings in terms of power, persistence, quality
and growth
• Solvency

© Mary Low
 Effective Financial Statement Analysis
• To perform an effective financial statement
analysis, you need to be aware of the
organisation’s:
– business strategy
– objectives
– annual report and other documents like articles about
the organisation in newspapers and business reviews.
These are called individual organisational factors.

© Mary Low
Effective Financial Statement Analysis
Requires that you:
• Understand the nature of the industry in which
the organisation works. This is an industry
factor.
• Understand that the overall state of the
economy may also have an impact on the
performance of the organisation.

→ Financial statement analysis is more than just

“crunching numbers”; it involves obtaining a
broader picture of the organisation in order to
evaluate appropriately how that organisation is
performing
© Mary Low
 Tools of Financial Statement Analysis:
The commonly used tools for financial statement
analysis are:
• Financial Ratio Analysis
• Comparative financial statements analysis:
– Horizontal analysis/Trend analysis
– Vertical analysis/Common size analysis/ Component
Percentages

© Mary Low
 Financial Ratio Analysis
• Financial ratio analysis involves calculating and analysing
ratios that use data from one, two or more financial
statements.
• Ratio analysis also expresses relationships between
different financial statements.
• Financial Ratios can be classified into 5 main categories:
– Profitability Ratios
– Liquidity or Short-Term Solvency ratios
– Asset Management or Activity Ratios
– Financial Structure or Capitalisation Ratios
– Market Test Ratios

© Mary Low
 Profitability Ratios
3 elements of the profitability analysis:
• Analysing on sales and trading margin
– focus on gross profit
• Analysing on the control of expenses
– focus on net profit
• Assessing the return on assets and return
on equity

© Mary Low
 Profitability Ratios
• Gross Profit % = Gross Profit * 100
Net Sales
• Net Profit % = Net Profit after tax * 100
Net Sales
Or in some cases, firms use the net profit before tax figure. Firms
have no control over tax expense as they would have over other
expenses.
 Net Profit % = Net Profit before tax *100
Net Sales

• Return on Assets = Net Profit * 100

Average Total Assets

• Return on Equity = Net Profit *100

Average Total Equity

© Mary Low
 Liquidity or Short-Term Solvency ratios
Short-term funds management
• Working capital management is important as it signals the firm’s ability
to meet short term debt obligations.

For example: Current ratio

• The ideal benchmark for the current ratio is $2:$1 where there are two
dollars of current assets (CA) to cover $1 of current liabilities (CL).
The acceptable benchmark is $1: $1 but a ratio below $1CA:$1CL
represents liquidity riskiness as there is insufficient current assets to
cover $1 of current liabilities.

© Mary Low
 Liquidity or Short-Term Solvency ratios
• Working Capital = Current assets – Current Liabilities

• Current Ratio = Current Assets

Current Liabilities

• Quick Ratio = Current Assets – Inventory – Prepayments

Current Liabilities – Bank Overdraft

© Mary Low
 Asset Management or Activity Ratios
• Efficiency of asset usage
– How well assets are used to generate revenues
(income) will impact on the overall profitability of the
business.

For example: Asset Turnover

• This ratio represents the efficiency of asset

usage to generate sales revenue

© Mary Low
 Asset Management or Activity Ratios
• Asset Turnover = Net Sales
Average Total Assets

• Inventory Turnover = Cost of Goods Sold

Average Ending Inventory

• Average Collection Period = Average accounts Receivable

Average daily net credit sales*

* Average daily net credit sales = net credit sales / 365

© Mary Low
 Financial Structure or Capitalisation Ratios
Long term funds management
• Measures the riskiness of business in terms of debt
gearing.

For example: Debt/Equity

• This ratio measures the relationship between debt and
equity. A ratio of 1 indicates that debt and equity funding
are equal (i.e. there is $1 of debt to $1 of equity) whereas
a ratio of 1.5 indicates that there is higher debt gearing in
the business (i.e. there is $1.5 of debt to $1 of equity). This
higher debt gearing is usually interpreted as bringing in
more financial risk for the business particularly if the
business has profitability or cash flow problems.

© Mary Low
 Financial Structure or Capitalisation Ratios
• Debt/Equity ratio = Debt / Equity

• Debt/Total Assets ratio = Debt *100

Total Assets

• Equity ratio = Equity *100

Total Assets

• Times Interest Earned = Earnings before Interest and Tax

Interest
© Mary Low
 Market Test Ratios

• Based on the share market's perception of the

company.

For example: Price/Earnings ratio

• The higher the ratio, the higher the perceived

quality of the earnings by the share market.

© Mary Low
 Market Test Ratios
• Earnings per share = Net Profit after tax
Number of issued ordinary shares

• Dividends per share = Dividends

Number of issued ordinary shares

• Dividend payout ratio = Dividends per share *100

Earnings per share

• Price Earnings ratio = Market price per share

Earnings per share
© Mary Low
 Horizontal analysis/Trend analysis
• Trend percentage
• Line-by-line item analysis
• Items are expressed as a percentage of a
base year
• This is a time series analysis
• For example, a line item could look at
increase in sales turnover over a period of
5 years to identify what the growth in sales
is over this period.

© Mary Low
 Vertical analysis/Common size analysis/
Component Percentages
• All items are expressed as a percentage of a
common base item within a financial statement
• e.g. Financial Performance – sales is the base
• e.g. Financial Position – total assets is the base
• Important analysis for comparative purposes
– Over time and
– For different sized enterprises

© Mary Low
Limitations of Financial Statement Analysis
• We must be careful with financial statement
analysis.
– Strong financial statement analysis does not
necessarily mean that the organisation has a strong
financial future.
– Financial statement analysis might look good but there
may be other factors that can cause an organisation to
collapse.

© Mary Low
Illustration: Financial statement analysis

• The following financial statements of Walker Ltd

were prepared in accordance with New Zealand
GAAPs. Walker Ltd is a diversified enterprise
with its main interests in the manufacture and
retail of plastic products.
• The financial statements of Walker Ltd need to be
analysed. An investor is considering purchasing
shares in the company. Relevant ratios need to
be selected and calculated and a report needs to
be written for the investor. The report should
evaluate the company’s performance and
position
© Mary Low
 Walker Ltd
Statement of Financial Position as at 31 March
2005 2006 Horizontal
Analysis
$000 $000 $000 $000
Current Assets
Bank 33.5 41.0
Accounts receivable 240.8 210.2
Inventory 300.0 370.8
574.3 622.0 108
Non-current assets
Fixtures & fittings (net) 64.6 63.2
Land & buildings (net) 381.2 376.2
445.8 439.4 99
Total assets 1,020.1 1,061.4 104

Current Liabilities
Accounts payable 261.6 288.8
Income tax 60.2 76.0
321.8 364.8 113
Non-current liabilities
Loan 200.0 60.0 30

Shareholders Funds
Paid-up ordinary capital 300.0 334.1
Retained profit 198.3 302.5
498.3 636.6 128
Total liabilities & equity 1,020.1 1,061.4 104

© Mary Low
 Walker Ltd
Statement of Financial Performance for year ended 31 March
2005 2006 Horizontal
Analysis
$000 $000 $000 $000
Sales 2,240.8 2,681.2 120
Less Cost of goods sold 1,745.4 2,072.0 119
Gross profit 495.4 609.2 123
Wages & salaries 185.8 275.6
Rates 12.2 12.4
Heat & light 8.4 13.6
Insurance 4.6 7.0
Interest expense 24.0 6.2
Postage & telephone 9.0 16.4
Depreciation -
Buildings 5.0 5.0
Fixtures & fittings 27.0 276.0 32.8 369.0 134

Net profit before tax 219.4 240.2 109

Less Income tax 60.2 76.0 126
Net profit after tax 159.2 164.2 103

© Mary Low
 Walker Ltd
Statement of Cash Flows for the year ended 31 March
2005 2006
$000 $000 $000 $000
Cash flow from operations
Receipts from customers 2,281 2,711.8
Payments to suppliers & employees (2,050) (2,460.4)
Interest paid (24) (6.2)
Tax paid (46.4) (60.2)
Net cash flow from operating activities 160.6 185
Investing activities
Purchase of non-current assets (121.2) (31.4)
Net cash used in investing activities (121.2) (31.4)
Financing activities
Dividends paid (32.0) (40.2)
Issue of ordinary shares 20.0 34.1
Repayment of loan capital -__ (140.0)
Net cash outflow from financing activities (12) (146.1)
Increase in cash & cash equivalents 27.4 7.5

© Mary Low
 Additional information:
• Credit purchases for the year 2006 were $2,142,800.
• General prospects for the major industries in which
Walker is involved look good with a forecast glut of oil set
to reduce the cost of production and world demand for
plastic remaining strong.
Benchmarks:
• There are no exact benchmarks for Walker Ltd because it
is a diversified company. The following are average
indicators that relate to the plastic retailing and
manufacturing industries for the year 2006.
– Gross profit margin 25%
– Net profit margin 7%
– Inventory turnover 6 times
– Debt/equity ratio 0.6 : 1
– Return on Assets 12%
– Return on Equity 20%

© Mary Low
Relevant ratios
Important note: The calculations of the ratios in this illustration did not use “averages” for total assets, equity and
inventory. The 2005 and 2006 year end figures were used and this is a slight variation to the formulas provided.

Profitability Benchmarks 2005 2006

ratios:

Gross Profit Industry 22% 22.7%

Margin 25%

Net Profit Industry 7.1% 6.1%

Margin 7%

Return on 12% 15.6% 15.5%

Assets

Return on Industry 32% 26%

Equity 20%

© Mary Low
 Asset Benchmarks 2005 2006
Management
ratios:
Inventory Industry 5.8 times 5.58 times
Turnover 6%

Asset Turnover Not given 2.2 2.53

© Mary Low
 Liquidity Benchmarks 2005 2006
ratios:
Current Ratio Ideal standard 1.78:1 1.70:1
2:1
Acceptable
standard
1:1
Quick Ratio Ideal standard 0.85:1 0.69:1
2:1
Acceptable
standard
1:1
Days Payable Standard Credit 49.19 days
30 days purchases not
available

© Mary Low
Financial Benchmarks 2005 2006
Structure
ratios:
Debt/Equity Industry 1.05: 1 0.67:1
0.6:1
Standard
benchmark
1:1
TIE Standard 10.14 times 39.74 times
benchmark:
Between 3 and 5.
Below 3 risky.
Above 5 very
favourable

© Mary Low
Report
• For the investor considering the purchase of shares in
the company, the return they will earn is the key financial
factor but an overall evaluation of the company’s
performance and position is also important to get a
better picture of how well the company is actually doing.
• ROE in 2006 is 26%. Whether or not this is attractive
depends on the perceived riskiness of this investment
and other alternatives available but this return is certainly
more attractive than current bank interest rates.
• ROE has decreased by 4% but the company’s ROE at
26% is still better than the industry average of 20%
• Riskiness of business is being reduced by the significant
repayment of loan in 2006.

© Mary Low
• Profitability
– The NP% and ROA ratios show a small downward
trend in % over the 2 year period. ROE% ratio show a
more significant decrease but is still better than the
industry average.
– Gross Profit Margin is slightly unfavourable at about
2.3% below the industry benchmark of 25%.
– The horizontal analysis information show that Sales
have increased by 20%. However operating costs
have increased by 34%.
• Asset Management
– IT has gone down slightly from 5.8 to 5.58 times.
– IT is still close to the industry benchmark of 6 times.
– AT has increased showing more sales being
generated from asset usage
© Mary Low
• Liquidity
– Current ratios of 1.78:1 (2005) and 1.70: 1 are at
above acceptable levels but below ideal level.
– Quick ratios appear more of a concern being below
acceptable levels in both years and even more so in
2006 (0.69:1).
– Raises some concerns over the liquidity of the
business and inventory management (although IT
ratio only shows a slight decline in 2006).
– Days Payable is a concern as there may be poor debt
payment management.

© Mary Low
• Financial Structure
– Although slightly higher than D/E industry benchmark
(0.67:1), business has become less risky due to the
significant repayment of loan in 2006.
– TIE is extremely good for the business at 39.74 times
(well above 5 the standard benchmark).
• Cash flow situation
– Strong cash flow from operating activities (increased
from 160,600 to 185,000).
– Spending under investing activities suggest more
growth.
– Repayment of debt under financing activities imply
restructuring of business to have more equity funding
rather than debt funding.

© Mary Low
Recommendation
Given:
1) the strong forecast for the industry (ie general
prospects looking good and world demand for
plastic products remaining strong),
2) the sales growth in this business,
3) acceptable ratios as they are quite close to the
industry averages,
4) good cash flows from operating activities and
5) favourable ROE, although it has decreased, it
is still better than the industry average ROE.

=> it is recommended that the investor purchase shares

in the Walker Ltd company.

© Mary Low