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Topic 5
Financial Statement Analysis
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
Comment on the differences.
($millions) 2010 2011
AVGCash 52 27
AVGInventories 335 407
AVGReceivables 64 58
AVG Payable 290 302
Sales 2731 2959
COGS 2137 2307
WCM Revision
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
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
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
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
$ Change for
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
Can be misleading if youre making comparisons
between companies
(Hint for project)
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
- Anything on the P&L is divided by sales (top line)
- Anything on the BS is divided by assets
- Anything on the BS is divided the total in its own
e.g. Bank loans as a proportion of total liabilities,
cash divided by total assets
Also called common size financial statements
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
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
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%
made an
with WOW,
DJ S and
QAN (2011),
but forgot to
label them.
Which one is
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
A Note on Ratios
There are large variations in ratios.
Ill cover the vanilla ratios
More complex ratios make adjustments for various
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
Profitability Ratios
Measures the profitability of either assets, equity, or
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)
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%
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
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)
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
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
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
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.
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)
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.
Problem With Ratios and FSA
When companies change accounting treatments,
youll get changes in ratios even if nothing really
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
(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
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
- Profitability
- Operating Efficiency
- Financial Risk
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:
=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