Analysis of Financial

Statements and
Financial Planning and
Controls
 Analysis of Financial Statements
The income statement
ƒ Presents the results of business operations
during a specified period of time
ƒ Summarizes the revenues generated and the
expenses incurred by the firm during the
accounting period
ƒ Earnings per share
 Analysis of Financial Statements
The balance sheet
ƒ Shows the financial position of a firm at a
specific point in time
ƒ Assets
ƒ Liabilities and equity
 Analysis of Financial Statements
Assets
ƒ Cash
ƒ Receivables
ƒ Inventories
ƒ Fixed assets
 Analysis of Financial Statements
Liabilities and stockholders’ equity
ƒ Liabilities represent what the company owes
ƒ Equity represents the owners equity
 Analysis of Financial Statements
Financial statements and alternative accounting
methods

The time dimension

Analysis of Financial Statements

Statement of retained earnings

ƒ Represent changes in the common equity
accounts between balance sheet dates
 Analysis of Financial Statements
Income vs. cash flow
ƒ Accounting concentrates on income
ƒ Finance concentrates on cash flow
 Analysis of Financial Statements
Depreciation
ƒ The matching of revenues and expenses
ƒ Depreciation is the means by which the reduction in
the asset’s value, which is an operating cost, is
matched with the revenues the assets help to
produce
ƒ Depreciation is a non-cash charge used to compute
net income, so, if net income is used to obtain an
estimate of the net cash flow from operations, the
amount of depreciation must be added back to the
income figure
 Analysis of Financial Statements
Statement of Cash Flows
ƒ Shows how the firms operations have affected
its cash position
ƒ In addition to the cash generated as detailed
in the income statement, we must examine
changes in the balance sheet
 Analysis of Financial Statements
Identifying sources and uses of cash on the
balance sheet
ƒ Increases in liabilities or equity accounts are a
source of cash
ƒ Decreases in assets are a source of cash
ƒ Decreases in liabilities or equity accounts are
a use of cash
ƒ Increases in assets are a use of cash
 Analysis of Financial Statements
Financial analysis
ƒ Predicting the future is what financial analysis
is all about
ƒ Analysis of a firm’s ratio’s allows comparison
between firms
ƒ Ratios in themselves are meaningless unless
they are compared to industry norms
 Analysis of Financial Statements
Liquidity ratios
ƒ Current ratio = current assets/current liabilities
ƒ Quick ratio =
(current assets – inventories)/current liabilities
 Analysis of Financial Statements
Asset Management Ratios
ƒ Inventory Turnover =
cost of goods sold/Av. inventories
ƒ Days sales outstanding =
360/Receivable Turnover
ƒ Fixed asset turnover = sales/net fixed assets
ƒ Total assets turnover = sales/total assets
 Analysis of Financial Statements
Debt management ratios
ƒ Debt ratio = total debts/total assets
ƒ Times int. earned = EBIT / Interest charges
 Analysis of Financial Statements
Profitability ratios
ƒ Net profit margin on sales = net income/sales
ƒ Return on tot. assets = net income/tot. assets
ƒ Return on common equity =
net income available to stockholders/
common equity
 Analysis of Financial Statements
Market value ratios
ƒ Earnings per share =
net income available to common stockholders/
number of common shares outstanding
ƒ Price/earnings ratio =
market price per share/earnings per share
ƒ Book value per share = common equity/
number of common shares outstanding
ƒ Market/book ratio =
market price per share/book value per share
 Financial planning and control
ƒ Break Even Analysis – Profit Planning

Important in studying relationship between

volume, prices and costs.
 Financial planning and control
Breakeven computation
BEP (Units) = Fixed Costs
(Sale Price per unit – Variable Costs per unit)

BEP ($) = Fixed Costs

(1 - Variable Costs per unit / Sales Price per unit)

Cash Op Exp BEP = Fixed Costs – Non-cash Outlays

(Sales Price per unit – Variable Costs per unit)
 Financial planning and controls
Using operating breakeven analysis
ƒ When making new product decisions, breakeven analysis can
help determine how large the sales of a new product must be
for the firm to achieve profitability

ƒ May be used to study the effects of a general expansion in

the level of the firm’s operations; an expansion would cause
the levels of both fixed and variable costs to rise, but it also
would increase expected sales

ƒ When considering modernization and automation projects,

where the fixed investment in equipment is increased in order
to lower variable costs, particularly the cost of labor,
breakeven analysis can help management analyze the
consequences of purchasing these projects
 Financial planning and control
ƒ Break Even Analysis – Profit Planning

ƒ Limitations:
Weak in what it implies about sales
possibilities for the firm i.e. based on constant
sales prices
 Financial planning and control
Break Even Analysis – Profit planning

ƒ Limitations:
With regards costs – If sales increase at full capacity,
labor costs increase implies variable costs increase.
If additional equipment bought implies fixed costs
increases. Product may change in quality and
quantity. All these changes influence the level and
slope of the cost function.
 Financial planning and controls

Sales forecasts
ƒ Most important ingredient of financial
forecasting

ƒ Generally begins with a review of sales for the

past 5 or 10 years

ƒ Includes projections of expected economic

activity, competitive conditions, and product
development, as well as market expansion
 Financial planning and controls
Projected (pro forma) financial statements
Income statement

ƒ Based on sales forecast

ƒ Expenses that grow proportionately with sales

use percentages or utilize actual estimated
expenses
 Financial planning and controls
Balance sheet

ƒ Utilize percentages for those items which grow

in relationship to sales

ƒ Utilize actual estimates for other items

ƒ Fixed costs vs. variable costs

 Financial planning and controls
Based on pro forma financial statements the
firm must then determine what additional
funds will be needed and where to obtain
those funds
ƒ Will depend on how its debt ratio’s compare to
the industry average
ƒ Financing feedbacks
ƒ Once the pro forma financial statements are
complete, they must be analyzed to see if they
are reasonable and if they meet the firms
financial targets
 Financial planning and control
Other considerations for forecasting

ƒ Excess capacity
ƒ Economies of scale
ƒ Lumpy assets
 Financial planning and controls
Operating leverage
ƒ If a high percentage of the firm’s operating costs are
fixed, the firm is said to have a high degree of
operating leverage

ƒ Operating leverage can be defined more precisely in

terms of the way a given projected change in sales
volume affects net operating income (NOI), and this
is done by calculating the degree of operating
leverage (DOL)
 Financial planning and controls
DOL = % ∆ in NOI
% ∆ in sales

= ∆ in NOI/NOI
∆ in sales/sales
 Financial planning and controls
The resulting value of the degree of operating
leverage (DOL) means that for every degree
of increase in operating sales, there will be a
change in the net operating income (NOI) of
the value of DOL times the percentage
increase in operating sales
 Financial planning and controls
Financial leverage
ƒ While the degree of operating leverage (DOL)
considers how changing sales volume affects
operating income, degree of financial leverage (DFL)
considers the impact a change in operating income
has on earnings per share

ƒ DFL is defined as the percent change in earnings per

share (EPS) that results from a given percent
change in earnings before interest and taxes (EBIT)
 Financial planning and controls
DFL = % ∆ in EPS
% ∆ in EBIT

= ∆ in EPS/EPS
∆ in EBIT/EBIT