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Chapter 4

Financial Statements
Analysis Tools

Outline

Demand and supply of financial


analysis
Basic analytical procedures
Analysis methods
Comprehensive analysis of financial
ratios
The limitations of financial analysis

Demand and supply of


financial analysis
Demand
Demand
Investors
Investors
Managers
Managers
Employees
Employees
Customers
Customers
auditors
auditors
Government/regulatory
Government/regulatory
agencies
agencies

Supply
Supply

Internal
Internal analysts
analysts
Intermediaries
Intermediaries

Financial
Financial analysts
analysts
Bond
Bondrating
rating agencies
agencies

Basic Analytical Procedures

Determine
Determine
objective
objective

Contrive
Contrive
analysis
analysis
scheme
scheme

Collect
Collect
data
data

Analyze
Analyze
data
data

Conclude
Conclude

Goals of Financial
Analysis

To identify if there is an improvement


in the financial status of the firm.
To determine whether the target
financial performance has been
attained.
To determine the financial standing of
the firm in relation to its competitors
and the industry where it belongs.

Techniques of Financial
Statement Analysis

Horizontal analysis or Trend Percentages

Vertical analysis or common-size statements

Comparative financial statements are presented


side by side where the previous period is the
based period
Provides degree of relationship in % between
two accounts in the same period. Net Sales,
Total Assets

Ratio analysis percentages relating an


account to another account.

Ratio Analysis
Financial
Financial ratio
ratio analysis
analysisis
isthe
thecalculation
calculationand
and comparison
comparison
of
of ratios
ratios which
which are
arederived
derivedfrom
from the
the information
informationin
in aa
company's
company'sfinancial
financial statements
statements

Liquidity
Analysis

Efficiency
Analysis

Leverage
Ratios

Coverage
Ratios

Profitability
Ratios

Liquidity Ratios analysis


Current ratio

Current Assets
Current Liabilities

Quick ratio

Current Assets- Inventory


Current Liabilities

Accounts Payable
Turnover

Net Credit Purchases


Accounts Payable

Liquidity Ratios analysis


Average Payment
Period

360 days
Accounts Payable Turnover

Working Capital

Current Assets Less Current


Liabilities

LIQUIDITY RATIOS- evaluate the firms ability to meet


short-term obligations. High results indicates good
liquidity however, excessive high liquidity ratio may also
indicate poor financial management

Activity or Efficiency
Ratios Analysis
Fixed Asset Turnover

Accounts Receivable
Turnover

Net Sales
Net Fixed Assets
Net Credit Sales
Net Accounts Receivable

Average collection
period

360 days
Accounts Receivable
Turnover

Finished Good
Inventory Turnover

Cost of Goods Sold


Finished Goods Inventory

Activity or Efficiency
Ratios Analysis
Total Assets
Turnover

Days Sales

Net Sales
Total Assets
360 days
Finished Goods Inventory
Turnover

Work in Process
Inventory Turnover

Cost of Goods Manufactured


Work in Process Inventory

Raw Materials
Inventory Turnover

Raw Materials Used


Raw Materials Inventory

Activity or Efficiency
Ratios Analysis
Days Production

Days Usage

Operating Cycle

360 days
Work in Process Inventory
Turnover
360 days
Raw Materials Inventory Turnover
Days usage + Days
production + days sales+
days collection

Activity Ratios- evaluate the firms efficiency in utilizing


its assets.
Efficiency is maximized by minimizing the investment in
assets and maximizing the sales potential at any level of

Leverage Ratios
Total Debt Ratio

Total Liabilities
Total Assets

Debt to Equity Ratio

Total Liabilities
Stockholders Equity

Stockholders Equity
Equity to Assets
Total Assets

Leverage Ratios
Number of Times
interest is earned

Net Income before interest and


taxes
Interest Expense

LEVERAGE RATIOS measure the solvency


of the firm.
Determines the firms dependence to its
creditors in relation to equity and
internal financing
Evaluates the capacity of the firm to
pay the interest of long term
obligations.
Indicates the ability of the business to
withstand adverse business conditions.

Coverage Ratios
Times Interest
Earned Ratio

Cash Coverage
Ratio

EBIT
Interest Expense
EBIT + Non Cash Expenses
Interest Expense

Profitability analysis
Gross Profit
Margin

Gross Profit
Net Sales

Return on Equity

Net Income After Tax


Stockholders Equity

Net Profit Margin

Net Income after tax


Net Sales

Return on Assets

Net Profit after tax


Total Assets

PROFITABILITY RATIOS- indicate the companys


ability to generate profits to be able to recover its
operating expenses

Profitability analysis
Return on Total
Assets

Net Income
Total Assets

Return on Equity

Net Income
Total Equity

Return on Common
Equity

Net Income Available to Common


Equity
Common Equity

Trend Analysis
Comparing a companys financial
condition and performance across
time

A Compare of Companys
Profitability

Why ratio analysis is


useful?

They facilitate inter-company comparison;


They downplay the impact of size and allow
evaluation over time or across entities without
undue concern for the effects of size difference;
They serve as benchmarks for targets such as
financing ratios and debt burden;
They help provide an informed basis for making
investment-related decisions by comparing an
entitys financial performance to another;

How is ratio analysis limited?

It is restricted to information
reported in the financial statements;
It is based on past performance.
Comparability is hampered when
accounting policies are not uniform
across an industry;
The past may not predict the future;

How is ratio analysis


limited? (cont)
Trends and relationships must be
carefully evaluated with reference
to industry norms, budgets, and
strategic decisions;
Because of some potential
problems in standard, comparison
must be careful;

Potential problems and


limitations of financial ratio
analysis

Comparison with industry averages is


difficult for a conglomerate firm that
operates in many different divisions.
Average performance is not
necessarily good, perhaps the firm
should aim higher.
Seasonal factors can distort ratios.
Window dressing techniques can
make statements and ratios look better.

More issues regarding


ratios

Different operating and accounting


practices can distort comparisons.
Sometimes it is hard to tell if a ratio
is good or bad.
Difficult to tell whether a company
is, on balance, in strong or weak
position.

What should an analyst keep


in mind about financial analysis?

An overview of all ratios can provide


important information concerning the
strategic decisions of a company and
the nature of its business;
However, accounting information can
only provide so much data. An analyst
must proceed with caution;

Summary

Users of financial statements often


gain a clearer picture of the
economic condition of an entity by
the analysis of accounting
information;
The analytical measures obtained
from financial statements are usually
expressed as ratios or percentages;

Summary

Financial analysis techniques work


best when they are used to confirm
or refute other information. When
using analytical tools to evaluate a
company, the analyst should keep in
mind the limitations of analysis