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Topic 5

Financial Statement Analysis

MGSM840

George Li

SCF Revision

Yet more revision on SCF

Take note, you may find this useful for your

assignment due next week.

WCM Revision

Calculate the cash conversion cycle for 2010 and

2011.

Comment on the differences.

JBHiFi

($millions) 2010 2011

AVGCash 52 27

AVGInventories 335 407

AVGReceivables 64 58

AVG Payable 290 302

Sales 2731 2959

COGS 2137 2307

6/02/2013

2

WCM Revision

Change

Days in Inventory 57.22 64.39 7.18

Days in Receivables 8.55 7.15 -1.40

Days in Payables 49.53 47.78 -1.75

CCC 16.24 23.77 7.53

Outline of this class

What is Financial Statement Analysis?

Why FSA?

Basics horizontal and vertical analysis

Ratios as tools

Issues with FSA

What is Financial Statement Analysis?

A set of tools and techniques to analyse complex

information that is contained in a set of accounting

reports.

6/02/2013

3

Why FSA?

Decision making!

If youre a potential investor, you will want to

investigate the performance and risk of the business

(What you are doing for your project)

For managers, you also want to look at various

aspects of business performance

Which areas show signs of strength? Which areas

show weaknesses?

How do we fare in comparison to our competitors?

Capitalise on your strengths, eliminate your

weaknesses, go to war with your competitor.

Your First Look at an Annual Report

George

Class

Tools and Techniques

Without a set of tools and techniques to dig into the

numbers, you become overwhelmed

Information overload

Lets start off with horizontal and vertical analysis

6/02/2013

4

Horizontal Analysis

Fancy schmancy name for something not so fancy

Basically we compute changes

- $ changes

- % changes

The first step in identifying trends

Horizontal Analysis Example ($)

Calculate $ changes for companies A and B

Who is doing better A or B?

A - 2010 A - 2011 B - 2010 B - 2011 $ Change for

A

$ Change for

B

Revenues $900,000 $950,000 $500,000 $540,000 $50,000 $40,000

Expenses $750,000 $740,000 $400,000 $390,000 ($10,000) ($10,000)

Profit $150,000 $210,000 $100,000 $150,000 $60,000 $50,000

Horizontal Analysis

Using $ changes is okay if youre looking at one

company

Can be misleading if youre making comparisons

between companies

(Hint for project)

6/02/2013

5

Horizontal Analysis Example (%)

Now, repeat what you did before, but with % change

To calculate % change,

(short cut) use %chg =(later $/earlier $) 1

A - 2010 A - 2011 B - 2010 B - 2011 % Change

for A

% Change

for B

Revenues $900,000 $950,000 $500,000 $540,000

5.56% 8.00%

Expenses $750,000 $740,000 $400,000 $390,000

-1.33% -2.50%

Profit $150,000 $210,000 $100,000 $150,000

40.00% 50.00%

Horizontal Analysis

Horizontal analysis can be conducted on any

financial statement, provided you have more than 1

year of data.

Useful as a tool for identifying trends

Vertical Analysis

Another fancy name

Plain English: convert $ numbers into proportions of

another number

Typically:

- Anything on the P&L is divided by sales (top line)

- Anything on the BS is divided by assets

OR

- Anything on the BS is divided the total in its own

group

e.g. Bank loans as a proportion of total liabilities,

cash divided by total assets

Also called common size financial statements

6/02/2013

6

Vertical Analysis

For example, you can divide bank loans by total

assets or total liabilities.

Whats the difference?

When you divide by total liabilities, youre asking: out

of my total liabilities, what proportion is my bank

loan?

When you divide by total assets, youre asking: out

of my total funding (debt and equity), what proportion

are my bank loans?

Be flexible with your approach depending on your

question!

Fun With Common Sized Statements

Profit and Loss Statement 1 2 3

Sales Revenue 100.0% 100.0% 100.0%

Expenses 92.5% 86.1% 89.0%

EBITDA 7.5% 13.9% 11.0%

EBIT 6.0% 11.5% 2.3%

Profit after tax 3.9% 8.1% 1.2%

Balance Sheet

Cash 3.9% 1.5% 18.6%

Receivables 1.2% 0.7% 4.1%

Inventory 18.6% 23.6% 1.6%

Current Assets 28.1% 27.5% 29.3%

PPE 41.3% 63.7% 62.9%

Intangibles 27.4% 3.0% 3.4%

Total Assets 100.0% 100.0% 100.0%

George

made an

example

with WOW,

DJ S and

QAN (2011),

but forgot to

label them.

Which one is

which?

Ratios

Ratios can be separated into 3 rough areas

(some ratios overlap these areas)

1) Profitability

2) Operating efficiency (inc. WCM)

3) Financial risk, including short term liquidity risk

Well also look at ratios involving share prices

6/02/2013

7

A Note on Ratios

There are large variations in ratios.

Ill cover the vanilla ratios

More complex ratios make adjustments for various

reasons.

For your sanity, lets stick with the simplest versions

of these ratios in class.

For your project, Im not too fussed on what you use,

as long as you document the variation you have

used.

Profitability Ratios

Measures the profitability of either assets, equity, or

sales:

Return on Assets (ROA)

- Profit/Assets

Return on Equity (ROE)

- Profit/Equity

Profit Margin

- Profit/Sales

Profitability Ratios

Different profits can be used here:

- Gross Profit (i.e. sales cogs)

- EBIT

- EBITDA

- NPAT

6/02/2013

8

Profitability Ratios - Examples

Sales are $8m, after tax profits are $2m, total assets

are $20m, while total equity is $10m.

Calculate the after tax ROA, ROE and profit margin.

After tax ROA =$2m/$20m =10%

After tax ROE =$2m/$10m =20%

After tax profit margin =$2m/$8m =25%

Financial Risk (Leverage)

Measure the amount of debt you have

These measures are also called leverage because

you use debt to leverage your returns

Common measures:

- Debt to Assets =Liabilities/Assets

- Equity to Assets =Equity/Assets

- Debt to Equity =Liabilities/Equity

(These three ratios are almost equivalent. Pick one

for your project. Waste of space otherwise).

Financial Risk (Leverage) - Example

If A =$100m, L =$40m, calculate the Debt to Asset

and Debt to Equity ratios

Debt to Assets =$40m/$100m =0.4 or 40.0%

Debt to Equity =$40m/$60m =0.667 or 66.7%

6/02/2013

9

Liabilities vs. Interest Bearing Debt

So far, we have equated liabilities with debt.

This is technically not true, as not all liabilities are

interest bearing (e.g. accounts payables)

Some may prefer to use Interest Bearing Liabilities

in place of Total Liabilities.

(If you decide to do this in your project. Make a

mention of it somewhere so I know.)

Note on Financial Risk (Leverage)

Debt is risky because youre obligated to pay interest.

Having insufficient cash to pay interest can result in

bankruptcy

But debt is also beneficial!

Borrow at 10% interest, invest for a return of 20%,

money in the hands of shareholders (hence leverage)

But what determines how much you can (or should)

borrow?

Note on Financial Risk (Leverage)

Imagine two businesses, A and B with equal assets

($100m). The following operating cash flows have

been projected:

Assuming all excess cash is returned to the

shareholders as dividends, which of the two

companies have greater financial risk if they both

borrow $30m?

(clearly both would have the same D/A ratios)

Y 1 Y 2 Y 3 Y 4

A $50m $50m $50m $50m

B $70m $30m $70m $30m

6/02/2013

10

Note on Financial Risk (Leverage)

While D/A, E/A and D/E ratios measure your capital

structure, they dont tell the full story about financial

risk

Financial risk is also about your ability to service your

debt using cash/profits.

Need more ratios

Interest Coverage Ratio (Times interest earned)

=EBIT/Interest Expense

Cash Cover

=(Net CF from OP +interest paid)/Interest Expense

Financial Risk Example

Given:

EBIT =$20m

Accrual interest expense =$5m

Cash interest paid =$4m

Net CF from OP =$11m

Calculate the Times Interest Earned and Cash Cover.

TIE =$20m/$5m =4 times

CC =($11m +$4m)/$5m =3 times

Short Term Liquidity

Ability to stay afloat in the short run. Overlaps with

financial risk.

Current Ratio

=Current Assets/Current Liabilities

Quick Ratio (Acid Test) [different variations exist]

=(Cash and equivalents +marketable securities +

accounts receivables)/Current Liabilities

Note that inventories/pre-payments are excluded

from this version of the quick ratio. In the event of

bankruptcy, it is unlikely for you to recoup the full cost

of your inventory.

6/02/2013

11

Short Term Liquidity Example

If Current Assets =$200m,

Current Liabilities =$250m,

What is the current ratio?

Current Ratio =200/250 =0.8

Does this mean that the company has insufficient

current assets to meet its current liabilities?

WOWs current ratio looks similar!

There is no rule of thumb with ratios.

Operating Efficiency

How well are you utilising your assets and liabilities?

Cash Conversion Cycle, Current Ratio

Other Ratios:

Asset Turnover (Asset Utilisation)

=Sales/Assets

Fixed Asset Turnover

=Sales/Fixed Assets

NWC Turnover

=Sales/Net Working Capital

Operating Efficiency Example

If Assets =$30m, Sales =$25m

Then Asset Turnover =$25m/$30m =0.833 times

That is, for every $1 you hold in assets, you generate

$0.83 in sales.

The higher this number, the more efficiently you are

using your assets.

6/02/2013

12

Problem With Ratios and FSA

When companies change accounting treatments,

youll get changes in ratios even if nothing really

changed

Abnormal events. E.g. machine burns down.

Creative accounting? Window Dressing?

Numbers are sometimes ambiguous. If you see

inventory building up, are they managing WC poorly,

or are they anticipating greater demand?

FSA is backwards looking, rather than forward

looking

(Thats why qualitative analysis is so important)

Problem With Ratios and FSA

Too MANY ratios!

We need an overarching framework for FSA that

includes profitability, financial risk, and operating

efficiency.

The answer is DuPont.

DuPont Analysis

Started by DuPont Corporation in the 1920s.

DuPont is a chemical engineering firm that used to

sell a lot of explosives

Created as an overarching framework for FSA that

incorporates:

- Profitability

- Operating Efficiency

- Financial Risk

6/02/2013

13

DuPont Analysis

ROA =Asset Turnover x Profit Margin

=(Sales/Assets ) x (Profit/Sales)

ROE =ROA x Leverage

=(Profit/Assets) x (Assets/Equity)

If we combine the two into one formula:

ROE

=Asset Turnover x Profit Margin x Leverage

=(Sales/Assets ) x (Profit/Sales) x (Assets/Equity)

DuPont Analysis

DuPont Analysis is extremely flexible, and can be

used to analyse many different types of decisions.

Remember that we did some work on WCM? We can

use DuPont to examine its impact on performance.

Next class: More DuPont

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