Financial Management

Financial Statement Analysis

Unit 2

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 Learning Objective 1

Using Ratio Analysis as the first step

in the analysis of a company’
Financial Statements

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 What is Ratio Analysis?

Examination of the relationships between

pieces of information in the financial
statements for a given accounting period

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 Why are ratios useful?
üThey standardize numbers – Ratios = % or times
üThey facilitate comparison – over time, other
companies
üThey are used to highlight the strengths and
weaknesses of a company relative to its industry
üSeveral ratios should be reviewed during an
analysis.
üWhen one ratio deviates from the norm, other
related ratios should be studied to help determine
the cause of the deviation.

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 Which Ratios are most important?

It depends on your perspective:

ØSuppliers and lenders are most interested in liquidity
ratios
ØLong-term debt holders are most interested in asset
management and debt management ratios
ØStockholders and potential investors are most
interested in profitability and market value ratios

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 Crystal Limited

Y/E 4/2014 Y/E 4/2013

Net sales $8,173,181 6,870,743
Cost of goods sold (6,008,011) (5,281,168)
Gross profit 2,165,170 1,589,575
Total operating expenses (1,444,076) ( 1,166,888)
Income from operations 721,094 422,687
Interest expense ( 114,813) ( 92,755)
Income before taxes 606,281 329,932
Income taxes ( 144,971) 23,249
Net income $ 461,310 353,181
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 Crystal Limited

Assets 2014 2013

Current assets:
Cash & S/T Inv. $ 500,580 $ 285,096
Trade Receivables 464,814 527,197
Inventories & Bio 1,228,185 1,074,642
Other S/T Rec. 203,382 505,789
Total current assets $ 2,396,961 $ 2,392,724
Property, Plant & Eqpt. 1,725,011 1,641,253
Other L/T Assets 904,997 357,890
Total assets $ 5,026,969 $4,391,867
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 Crystal Limited

Liabilities 2014 2013

Current liabilities:
S/T Borrowings $ 765,643 $ 501,322
Trade payable 578,439 428,930
Other S/T liabilities 466,969 357,485
Total current liabilities $1,811,051 1,287,737
L/T borrowings 212,834 501,563
Other L/T liabilities 354,883 300,663
Total liabilities 2,378,768 2,089,963

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 Crystal Limited

Stockholders’ Equity 2014 2013

Common stock $599,638 $513,976
Capital Reserve 858,631 838,971
Retained earnings 1,189,932 948,957
Total stockholders’ equity $2,648,201 $2,301,904

Total liabilities and

stockholders’ equity $5,026,969 $4,391,867
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 Crystal – Liquidity Ratios

Y/E 4/2014 Y/E 4/2013

•Current Ratio
= Current Assets 2,396,961 2,392,724
Current Liabilities 1,811,051 1,287,737

= 1.32 X = 1.86X
•Quick Ratio
= CA – Inventory 1,168,776 1,318,082
Current Liabilities 1,811,051 1,287,737
= 0.65 X = 1.02 X
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 Crystal – Liquidity Ratios

Y/E 4/2014 Y/E 4/2013

•Cash Flow Ratio
= Operating Cash Flow 1,243,558 135,148
Current Liabilities 1,811,051 1,287,737

= 0.69 X = 0.105X

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 Limitations of current ratio

ØCurrent ratio can become outdated easily – short

term assets and liabilities can change overnight.
ØCompany year-end position may differ from other
times in the year – Crystal Ltd peaks at Christmas,
lent season and other holidays
ØPresent position is not an indication of future cash
position or adequacy

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 ASSET MANAGEMENT RATIOS

How efficient is the company in the use of its

assets?

q Asset turnover measures the intensity and

efficiency with which companies utilize and
manage assets.

q The relevant measure is the

amount of sales
generated
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Crystal – Asset Management Ratios

Y/E 4/2014 Y/E 4/2013

•Total Asset Turnover
= Sales 8,173,181 6,870,743
Total Assets 5,026,969 4,391,867

= 1.63 X = 1.56 X
•Fixed Asset Turnover
= Sales 8,173,181 6,870,743
Fixed Assets 1,725,011 1,641,253
= 4.74 X = 4.19 X
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Crystal – Asset Management Ratios

Y/E 4/2014 Y/E 4/2013

•Accounts Receivable Turnover
= Sales 8,173,181 6,870,743
Accounts Rec. 464,814 527,197
= 17.58 X = 13.03 X

•Days Sales in Receivables

= Accounts Rec 464,814 527,197
Average Sales/ day 8,173,181/365 6,870,743/365
= 21 days = 28 days
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Crystal – Asset Management Ratios

Y/E 4/2014 Y/E 4/2013

•Days Sales in Receivables
= Accounts Rec 464,814 527,197
Average Sales/ day 8,173,181/365 6,870,743/365
= 21 days = 28 days

Also called:
• Average Collection Period
• Days Sales Outstanding

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 Crystal – Asset Management Ratios

Y/E 4/2014 Y/E 4/2013

•Inventory Turnover
= COGS 6,008,011 5,281,168
Inventory 1,228,185 1,074,642
= 4.89 X = 4.91 X

•Days Sales in Inventory

= Inventory 1,228,185 1,074,642
Avg. COGS/day 6,008,011/365 5,281,168/365
= 75 days = 74 days
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 Inventory Turnover
High Ratio
May be sign of efficiency, high sales or that the
company is living from hand to mouth,
providing little variety to customers and may
sometimes be out of stock.

Low Ratio
ØMay be holding obsolete stock.
ØMay be holding too much stock
ØNeed to question current ratio

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 Asset Management
Total Assets Turnover Ratio
= Sales ÷ Total Assets
To improve ratio:
ØIncrease Sales
ØImprove efficiency of use of assets
ØDispose of or replace some assets
ØA combination of the above

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 Measuring Ability to
Pay Debt

The debt ratio indicates the proportion

of assets financed with debt.

Total liabilities ÷ Total assets

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Crystal – Debt Management Ratios

Y/E 4/2014 Y/E 4/2013

•Total Debt Ratio
= Total Debt 2,378,768 2,089,963
Total Assets 5,026,969 4,391,867

= 47 % = 48 %
•Debt to Equity Ratio
= Total Debt 2,378,768 2,089,963
Total Equity 2,648,201 2,301,904
= 0.90 X = 0.91 X
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 Debt Management Ratios
What does a high debt ratio mean?
ØLess cushion against creditors loss in the
event of liquidation
ØMay be costly to raise additional debt
capital without first raising more
equity capital
ØCreditors may be reluctant to lend more
ØRisk of bankruptcy if increased further

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Crystal – Debt Management Ratios

Y/E 4/2014 Y/E 4/2013

•Equity Multiplier
= Total Assets 5,026,969 4,391,867
Total Equity 2,648,201 2,301,904

= 1.90 X = 1.91 X
•Times Interest Earned
= EBIT 721,094 422,687
Int. Charges 114,813 92,755
= 6.28 X = 4.56 X
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 Debt Management Ratios
How well do we manage or use debt?
ØCompanies use borrowed funds to increase the
returns to company owners while
ØTo have a positive leverage you must be able to
earn a greater return on the assets the
borrowed money is invested in than the
interest cost.
ØIf the rate of return on assets < the rate of interest
on borrowed money, interest must be paid
and it will come from the owners capital.

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 Profitability Ratios

Ø Profitability analysis is a key part of

financial statement analysis
Ø All financial statements are pertinent to
profitability analysis
Ø Profitability ratios show the combined
effects of liquidity, asset management and
debt on operating results

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 Crystal – Profitability Ratios

Y/E 4/2014 Y/E 4/2013

•Gross Profit Margin
= Gross Profit 2,165,170 1,589,575
Net Sales 8,173,181 6,870,743

= 26.5% = 23%
•Net Profit Margin
= Net Income 461,310 353,181
Net Sales 8,173,181 6,870,743
= 5.64 % = 5.14 %
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 Crystal – Profitability Ratios

Y/E 4/2014 Y/E 4/2013

•Operating Profit Margin
= EBIT 721,094 422,687
Net Sales 8,173,181 6,870,743

= 8.82 % = 6.15 %
Reminder:
Income from Operations
= Operating Profit (Income)
= Earnings Before Interest & Tax (EBIT)
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 Profitability Ratios:
Profit Margin on Sales

Low Profit Margin?

ØCosts may be too high
ØOperations may be inefficient
ØCompany may have heavy use of Debt

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 Crystal – Profitability Ratios

Y/E 4/2014 Y/E 4/2013

•Return on Assets (ROA)
= Net Income 461,310 353,181
Total Assets 5,026,969 4,391,867

= 9.18 % = 8.04 %
•Return on Equity (ROE)
= Net Income 461,310 353,181
Total Equity 2,648,201 2,301,904
= 17.42 % = 15.34%
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 Crystal – Profitability Ratios

Y/E 4/2014 Y/E 4/2013

•Basic Earning Power Ratio
= EBIT 721,094 422,687
Total Assets 5,026,969 4,391,867
= 14.34 % = 9.62 %

•Return on Capital Employed (ROCE)

= Net Income 461,310 353,181
Total Capital 5,026,969 4,391,867
= 9.18% = 8.04%
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 Profitability Ratios:
Basic Earning Power
Basic Earning Power Ratio (BEP)
= EBIT ÷ Total Assets

ØThis ratio measures the raw earning power of

the firm’s assets
ØUseful for comparing companies with different
financing structures and tax rates.

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 Crystal – Market Value Ratios

Y/E 4/2014 Y/E 4/2013

•Earnings per share
= Net Income 461,310 353,181
# of shares 1,199,277 1,199,277

= 38.47 cents = 29.45 cents

•Price/Earnings (P/E) Ratio
= Market Price/Share 3.34
Earnings/share 0.3847
= 8.68 X
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 Market Value Ratios:
What do these ratios mean?

üIndication of how investors feel about the

company’s past performance and future
prospects.
üHigh ratios indicate good prospects and is
expected if all other ratios are good
üHigh P/E ratio may indicate that the market
expects an increase in earnings in the future
üP/E ratio higher for firms with strong growth
prospects. Low Ratio – higher risk

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 Learning Objective 2

Using trend analysis

to compare financial
Yr1
statements.
Yr2 Yr3

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 What is Trend Analysis?
ØThis is the evaluation of consecutive financial
statements of a company over time
ØIt shows the direction, speed and extent of any
trends in the company’s performance
ØTrend analysis shows the year-to-year changes
of a company or index-number trends
ØThe impact of inflation needs to be considered
in doing a trend analysis

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 Trend or Horizontal Analysis

The study of percentage changes in comparative

statements is called trend or horizontal analysis.
1. Compute the dollar amount of the change
from the base period to the later period.
2. Divide the dollar amount of change
by the base-period amount.

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 Horizontal or Trend Analysis

Increase/
In thousands 2014 2013 (Decrease)
Sales $8,173,181 $6,870,743 $1,302,438

$1,302,438 ÷ $6,870,743 = 0.1896, or 18.96%

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 Comparative Income Statement –
Horizontal Analysis
(Dollar amounts in millions) 2014 2013 Inc./(Dec.) Percent
Net sales $8,173 $6,871 $1,302 18.95
Cost of goods sold ( 6,008) ( 5,281) ( 727) 13.77
Gross profit $2,165 $ 1,590 $ 575 36.16
Total Operating expenses ( 1,444) ( 1,167) ( 277) 23.74
Income from operations $ 721 $ 423 $ 298 70.45
Interest Expenses ( 115) ( 93) ( 22) 23.66
Earnings before taxes $ 606 $ 330 $ 276 83.64
Income taxes ( 145) 23 ( 168) (730.43)

Net earnings $ 461 $ 353 $ 108 30.59

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 Learning Objective 3

Perform a comparative, vertical

or common-size analysis
of financial statements.

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 Vertical Analysis

Vertical analysis reveals the relationship

of each statement item to a specified
base, which is the 100% figure.

Every other item on the financial statement

is then reported as a percentage of that base.

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 Comparative Income Statement –
Vertical Analysis
(Dollar amounts in millions) 2014 Percent 2013 Percent
Net sales $8,173 100.0 $ 6,871 100.0
Cost of goods sold 6,008 73.5 5,281 74.4
Gross profit $ 2,165 26.5 $ 1,590 25.6
Total Operating expenses 1,444 17.7 1,167 17.6
Income from operations $ 721 8.8 $ 509 8.0
Interest expenses 115 1.4 87 1.7
Earnings before taxes $ 606 7.4 $ 422 6.3
Income taxes 145 1.8 79 1.0
Net earnings $ 461 5.6 $ 343 5.3

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 Learning Objective 4

Using benchmarking to
analysis the performance
of a company
relative to other companies

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 Benchmarking

Benchmarking is the practice of

comparing a company to other companies.

Common-size statements are also used to

compare the company to a specific company.

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 Learning Objective 5

Limitations of using
financial statement analysis
in decision making.

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 The Limitations of
Financial Analysis

No single ratio or one-year figure should

be relied upon to provide an assessment
of a company’s performance.

Financial analysis may indicate that

something is wrong, but it may not
identify the specific problem or
show how to correct it.
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Use Financial Statement Analysis
with Caution
Ø Do not restrict the use of a single ratio to a single
purpose – it can indicate profitability/performance
as well as flexibility/adaptability
Ø Do not use ratios in isolation from other
supporting ratios.
Ø Use ratios within the context of the industry. Also
remember the impact of inflation and size.
Ø Seasonal factors can distort ratios.
Ø Sometimes comparing a company with an industry
average can be misleading because some
companies operate in more than one industry.
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 Learning Objective 6

Considering Qualitative Factors

in the Analysis of
Financial Statements

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 Some Qualitative Factors to Look
For:

ØAre the company’s revenues tied to 1 key

customer?
ØTo what extent are the company’s revenues
tied to 1 key product?
ØTo what extent does the company rely on a
single supplier?
(More…)
 More Qualitative Factors
ØWhat percentage of the company’s business is
generated overseas?
ØCompetition
ØFuture prospects
ØLegal and regulatory environment
 Information Sources for
Financial Analysis
Quantitative/Ratios Qualitative
Financial Statements Management
Discussion & Analysis
Industry Statistics Chairperson’s Letter
Economic Indicators Vision/Mission
Regulatory filings Statement
Trade reports Financial Press
Press Releases
Web sites

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 Jamaican Sources
Bank of Jamaica –
http://www.boj.org.jm/home30.html
Statistical Institute of Jamaica (STATIN) – http://
www.statinja.com/
The Jamaica Stock Exchange –
http://www.jamstockex.com/
Financial section of newspapers
Annual and interim reports of companies
Web-sites of companies
Stock brokers and other financial services companies

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