ANALYSIS OF FINANCIAL STATEMENTS

We will see how financial statements can be analyzed by the

firm’s management as well as outsiders.
Significant changes are easier to see when financial statements amounts for two
or more years are placed side by side in adjacent columns.

TOOLS OF ANALYSIS:

1) Dollar and Percentage Changes

2) Trend Percentages
3) Component Percentages
4) Ratios
5) Standards of comparison
a. Past performance of the company
b. Industry Standards(Averages)
c. Results of Similar Companies in the Industry

OTHER CONSIDERATIONS IN ANALYSIS:

a) Quality of Earnings (Eg. Were earnings based on LIFO or FIFO?).

b) Quality of Assets and Relative Amounts of Debt

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1) Dollar and Percentage Changes:

Sales increased by $100,000 in each year in absolute dollar terms, but in

percentage terms the increase was 25% in 2004 as compared to 20% in 2005 i.e.
the rate of growth slowed down in 2005.

Evaluating Percentage changes in Sales and Earnings

Sales and earnings should increase more than the rate of inflation. This
would mean that sales volume and earnings have improved.

Percentages become misleading when the base is small

2005 2004 2003

Net Profit $20,000 $ 5000 $1,000,000

Increase/Decrease 15,000 (995,000)

Percent Increase/Decrease 300% (99.5%)

The above increase of 300% is misleading.

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2) Trend Percentages

Trend percentages show the extent and direction of change.

Overall the above trend percentages show a profitable growing enterprise.

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3) Component Percentages (Common size statements)

By comparing component percentages of income statements of two

periods we can
analyze the (the reasons for) change in
the net profit to sales ratios of the two periods.
Component percentages also enable us to compare companies
of different sizes.

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Component Percentages Balance Sheet

Component percentages indicate the relative size and importance of each

item included in the total. In a balance sheet it shows relative importance of each
type of asset in the total assets. It also shows relative amount of financing
obtained from current creditors, long-term creditors and stock holders.

Among other things the above analysis shows that Seacliff Company chose to
finance its growth through equity rather than through additional
debt.

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4) RATIOS
a)ANALYSIS BY COMMON SHAREHOLDERS

Stockholders look at the profitability and solvency of the company. They want to
assess the likelihood of dividends and price appreciation of the stock.

MARKET VALUE RATIOS

This group of ratios relate firm’s stock price to its earnings and book value/share.
Ratios mentioned below at serial numbers (ii) and (iii) are market value ratios.

i) Earnings per share of common stock

Decline in earning/share is seen unfavorably by shareholders. Normally this

reduction represents a decline in profitability of the company. So we should
expect a decline in the market value of the shares of this company.

ii) Market/Book Ratio

Market/Book Ratio = Market price per share/Book value per share

This ratio indicates how the investors regard the company. Generally stocks of
companies that earn high rates of return on their assets sell at prices much above
the book values.
Calculation: Book value per share= Common equity/Number of common shares outstanding.

2005 2004
Market price per share $ 132 $ 160
Book value per share 538,000/5,000 = $107.60 416,000/4000 = $104
Market/Book Ratio 132/107.60= 1.23 160/104= 1.54

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 𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑆ℎ𝑎𝑟𝑒
Ii) Price Earning Ratio =
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒

2005 2004

132 / 13.2 = 10 160 / 20.25 = 7.9

This ratio shows the investors’ expectations about the company’s future
performance. In Pakistan average P/E ratio is about 8.

𝑇𝑜𝑡𝑎𝑙 𝐴𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑

iii) Dividends per Share =
𝑇𝑜𝑡𝑎𝑙 𝑛𝑜.𝑜𝑓 𝑆ℎ𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔

2005 2004

24000 / 5000 = $4.80 20,000 / 4000 = $5.00

𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑒𝑟 𝑆ℎ𝑎𝑟𝑒

iv) Dividend Yield =
𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑆ℎ𝑎𝑟𝑒

This ratio is important for those investors who are more interested in dividend
revenue than in price appreciation of stocks ( like retired persons).

2005 2004
4.80 5.00
X 100 = 3.6 % X 100 = 3.1 %
132 160

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v) Operating Expense Ratio :

Management generally has greater control over operating expenses than over
revenue.

This ratio is a measure of management’s ability to control operating expenses.

Further analysis of expenses indicate that increase in selling expenses presumably

reflects greater selling effort during 2005 to improve sales. However selling
expenses increased by $42,000 while gross profit increased by only $40,000. Even
more bothersome is the increase in general and administrative expenses, which
increased from 12.7% to 14%.

PROFITABILITY RATIOS

These ratios show the combined effect of liquidity, asset management and debt
management on operating results.

vi) Return on Assets = Operating Income/Average Total Assets

Shows how efficiently and effectively the assets are being utilized. Whether the
management has earned a reasonable return using the assets under its control.

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Well managed companies should earn return on assets higher than the cost of
borrowing.

vii) Return on Equity = Net Income/Average Stockholder’s Equity

This ratio measures the rate of return on stockholders’ investment in the company.

viii)Net Profit Margin on Sales = Net Income/Sales

This ratio gives the profit per dollar of sales.

2005 2004

75,000/900,000=0.0833 =8.33% 90,000/750,000= 0.12 = 12%

In 2005 profit margin on sales reduced to 8.33% from 12% in 2004.

FINANCIAL LEVERAGE (Borrowing)

viii) Debt Ratio

It shows the proportion of assets financed by debt .

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When profitability is low, high levels of debt may be
risky for shareholders. However when return on
total assets is higher than the interest rate on
borrowed funds the rate of return to stock-holders
will be higher. In the above example the risk level for
the stock-holders was reduced in 2005.

ANALYSIS BY LONG-TERM CREDITORS (Debt

Management Ratios)
Bondholders and other long-term creditors are primarily interested in
3 factors:

a) The rate of return on investment.

b) The firm’s ability to meet interest requirements.

c) The firm’s ability to repay principal on due date.

i) Yield on Bonds = Annual Interest/ Price of Bond

Although interest rate on bonds is fixed, the market value of bonds

changes with the change in interest rates in the economy.

The yield varies inversely with changes in the market price of the bond.

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ii) Interest Coverage Ratio ( times interest earned)

A common measure of creditors’ safety.

Bondholders feel that their investments are relatively safe if the issuing company
earns enough income to cover its annual interest obligations by a comfortable
margin.

The above ratio of 5.3 times is considered to be quite high (of great comfort to
the creditors).

iii) Debt Ratio

From creditor’s point of view lower the debt ratio the better. This means that
stockholders have contributed higher percentage of funds in business which will
act as protection to the creditors against shrinkage of assets or losses.

The above change is good for the creditors as the debt ratio is reducing.

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ANALYSIS BY SHORT-TERM CREDITORS

Bankers and other short-term creditors share the interest of stockholders and
bondholders in the profitability of the and long term stability of the firm.
However, primary interest is in the current position of the business, i.e. its ability
to generate sufficient funds (working capital) to meet current operating needs
and to pay current debts promptly.

i) Net Working Capital = Current Assets – Current Liabilities

It represents cash and near cash assets that provide a cushion of liquidity over the
current needs and obligations maturing in the near future.

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 - Quality of the working capital
How liquid are the current assets?

ii) Accounts Receivable Turnover Rate

This shows how quickly A/c Receivables are collected or the number of days of
sales blocked in A/C Receivables.

iii) Inventory Turnover Rate

This shows how quickly inventory sells.

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iv) Operating Cycle =

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v) Current Ratio = Current Assets/ Current Liabilities
(Liquidity Ratio)

Shows favorable trend in short-term debt-paying ability. Ratio of 2:1 is considered

satisfactory.

vi) Quick Ratio (or Acid Test Ratio) = Quick Assets/ Current Liabilities
(Liquidity Ratio)

Quick Assets = Cash + Marketable Securities + A/C Rec.

It is a measure of company’s immediate short-term liquidity.

Ratio of 1.4: 1 shows a strong favorable liquidity position. Normally, a ratio of 1:1
is considered satisfactory.

v) Unused lines of credit

These are normally given in the notes to accounts. Short term creditors consider
unused credit lines as cash which the company can borrow to repay current
creditors.

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ASSET MANAGEMENT RATIOS

These ratios measure how efficiently firm is managing its assets.

We have already discussed
Inventory Turnover and Accounts Receivable Ratios under “Analysis by Short term Creditors”.

Fixed Assets Turnover

This ratio shows how effectively the firm uses its plant and equipment to help
generate sales.

Fixed assets turnover ratio = Net Sales/Net fixed assets

2005 2004

900,000/500,000 =1.8 750,000/467,000=1.6

The improvement from 1.6 to 1.8 shows that the firm utilized its fixed
assets more effectively in generating sales in 2005 when compared
with the year 2004. When compared with other firms in the industry
the ratio can also indicate whether the firm has made an appropriate
investment in fixed assets or has over invested.

Keep in mind that most firm’s record fixed assets at historical cost.
When comparing an older firm with a newer firm, the older firm may
have acquired fixed assets years ago at lower prices which results in
better fixed assets turnover. So use your judgment accordingly.

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Total Assets Turnover

This ratio shows how effectively the firm is using all its assets in generating sales.

Total assets turnover ratio = Net Sales/Total assets

2005 2004

900,000/ 950,000 = 0.95 750,000/860,000 = 0.87

The improvement in ratio from 0.87 to 0.95 shows that asset utilization in 2005
was better in generating sales as compared to 2004.

If this ratio is below the industry average it indicates that the firm is not
generating sufficient sales. To become efficient the firm should either increase
sales or should dispose some assets or a combination of these two steps.

Standards of Comparison
To pass judgment on the performance of a company, ratios etc
should be compared with:
a) Previous year’s ratios etc
b) Average industry ratios etc OR ratios etc of similar
companies in the industry.

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EARNING POWER AND IRREGULAR ITEMS
Earning power means the normal level of income expected in future.

Net income includes extraordinary items, whereas earning power is calculated

after removing from the income statement irregular revenues, expenses, gains
and losses.

Users are interested in earning power as it helps them in estimating future

earnings without any” distortions”.

Discontinued Operations refers to the disposal of a significant component of a

business. Eg a company dealing in paints and chemicals sells its chemical division.

Income (Loss) from discontinued operations has two parts:

1. Income(loss) from discontinued operations.

2. Gain(Loss) on sale of the business segment.
These two items will not appear in future income statements. So future earnings
should forecasted accordingly.

Extraordinary items are events and transaction which are (1) unusual in nature.
(2) infrequent in occurrence. Eg effects of volcanic activity, take-over of some part
of business by Government, effect of some new law like old property
condemnation or relating to pollution

Comprehensive Income includes all changes in stockholders’ equity during a

period except those resulting from investments by stockholders and distribution
to stockholders. It also includes items which by pass the income statement. Eg
unrealized gains and losses on available-for-sale securities.

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QUALITY OF EARNINGS
Different accounting methods result in different net profit.

Alternate Accounting Methods

If one company is using LIFO and another company is using FIFO when prices are
rising the one using LIFO has high quality of earnings.

Improper Recognition

Eg Callmate was recognizing sale of cards as revenue instead of Advances from

Customers.

ANALYSIS OF CASH FLOW STATEMENT on next two pages

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ANALYSIS OF CASH FLOW STATEMENT
We have been stressing the importance of a company being able to generate
sufficient cash flows from operations.

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In 2004, SEACLIFF generated net cash flows of $95,000 from its operating
activities – a relatively “normal” amount, considering that net income for 2004
was $90,000. Cash of $95,000 remained after payment of interest and amounted
to 3 times the dividends paid ($29,000). So in 2004 net cash flows from operating
activities appeared quite sufficient.

In 2005, net cash flows from operating activities declined to $19,000, an amount
far below net income of $ 75,000 and 58% of the amount of dividends paid
($33,000). Shareholders and creditors would view this dramatic decline in cash
flows as a negative and potentially dangerous development.

“Cash Flows from Operating Activities” section shows that main reasons for low
net operating cash flows appear to be the increase in uncollected accounts
receivable and inventories combined with substantial reduction in accrued
liabilities.

Contd…

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Cash Flows from Operations to Current Liabilities RATIO

An additional measure of liquidity. This ratio shows company’s ability to

cover its currently maturing liabilities from normal operations.

2005 2004

Cash Flows from Operations (a)$ 19,000 $ 95,000

Current Liabilities (b)$ 112,000 $ 94,000

Cash Flows from Operations to Current Liabilities (a/b) 0.17 1.01

From the above it will be seen that in 2004 operating cash flows were
slightly more than current liabilities at year end, indicating an ability to
cover current obligations from normal operations (without using the
existing current assets). In 2005, however, operations provided only
17% as much cash as is needed to meet current obligations, implying a
need to rely more heavily on existing current assets.

SUMMARY OF ALL FINANCIAL RATIOS IS GIVEN ON THE NEXT PAGE.

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TYING THE RATIOS TOGETHER: THE Du PONT
Table 13-2 summarized Micro Drive’s ratios, and now Figure 13-2 shows how the
return on equity is affected by
asset turnover

the profit margin

leverage.

The chart depicted in Figure 13-2 is called the modified Du Pont chart because that
company’s managers developed this approach for evaluating performance.

Working from the bottom up, the left side of the chart develops the profit margin
on sales. The various expense items are listed and then summed to obtain Micro
Drive’s total cost, which is subtracted from sales to obtain the company’s net
income. When we divide net income by sales, we find that 3.8 percent of each
sales dollar is left over for stockholders. If the profit margin is low or trending
down, one can examine the individual expense items to identify and then correct
problems.
The right side of Figure 13-2 lists the various categories of assets, totals them, and
then divides sales by total assets to find the number of times Micro Drive “turns its
assets over” each year. The company’s total assets turnover ratio is 1.5 times.
The profit margin times the total assets turnover is called the Du Pont equation,
and it gives the rate of return on assets (ROA):

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Limitations AFS

1. ENTIRELY DIFFERENT PRODUCTS SOLD BY THE FIRM: For such

companies it is difficult to develop a meaningful set of industry averages.
Analysis is more useful for small, narrowly focused firms

2. INDUSRTY AVEREGES: Most firms want to be better than average, so

merely attaining average performance is not necessarily good. As a target for
high-level performance, it is best to focus on the industry leaders’ ratios.
Benchmarking helps in this regard.

3. INFLATION DISTORTS FINANCIAL STATEMENT S & RATIOS: Inflation

may have badly distorted firms’ balance sheets—recorded values are often
substantially different from “true” values. Further, because inflation affects both
depreciation charges and inventory costs, profits are also affected. Thus, a ratio
analysis for one firm over time, or a comparative analysis of firms of different
ages, must be interpreted with judgment.

4. SEASONAL FACTORS can also distort a ratio analysis. For example, the
inventory turnover ratio for a food processor will be radically different if the
balance sheet figure used for inventory is the one just before versus just after the
close of the canning season. This problem can be minimized by using monthly
averages for inventory (and receivables) when calculating turnover ratios.

5. “WINDOW DRESSING” techniques make their financial statements look

stronger than they actually are. To illustrate, a Chicago builder borrowed on a
two- year basis in late December. Because the loan was for more than one year it
was not included in current liabilities. The builder held the proceeds of the loan as
cash. This improved his current and quick ratios, and made his year- end balance
sheet look stronger. However, the improvement was strictly window dressing; a
week later the builder paid off the loan and the balance sheet was back at the old
level.

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6. DIFFERENT ACCOUNTING PRACTICES can distort comparisons. As
noted earlier, inventory valuation and depreciation methods can affect financial
statements and thus distort comparisons among firms. Also, if one firm leases a
substantial amount of its productive equipment, then its assets may appear low
relative to sales because leased assets often do not appear on the balance sheet. At
the same time, the liability associated with the lease obligation may not be shown
as a debt. Therefore, leasing can artificially improve both the turnover and the debt
ratios.

7. It is DIFFICULT TO GENERALIZE about whether a particular ratio is “good”

or “bad.” For example, a high current ratio may indicate a strong liquidity posi-
tion, which is good, or excessive cash, which is bad (because excess cash in the
bank is a nonearning asset). Similarly, a high fixed assets turnover ratio may
denote either that a firm uses its assets efficiently or that it is undercapitalized and
cannot afford to buy enough assets.

8. A firm may have some ratios that look “good” and others that look “bad,”
making it difficult to tell whether the company is, on balance, strong or weak.
However, statistical procedures can be used to analyze the net effects of a set of
ratios.

9. Effective use of financial ratios requires that the financial statements upon
which they are based be accurate. Revelations in 2001 and 2002 of accounting
fraud by such industry giants as WorldCom and Enron showed that financial
statements are not always accurate, hence information based on reported data
can be misleading.

Ratio analysis is useful, but analysts should be aware of these problems and make
adjustments as necessary. Ratio analysis conducted in a mechanical, unthinking
manner is dangerous, but used intelligently and with good judgment, it can
provide useful insights into a firm’s operations.

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