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CHAPTER 5. FINANCIAL STATEMENT ANALYSIS. Financial Statement Analysis. Annual reports Auditor’s report Director’s report Statement of Financial Performance (Income statement) Statement of Financial Position (Balance sheet) Cash flow statement.

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FINANCIAL STATEMENT ANALYSIS

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CHAPTER 5

FINANCIAL STATEMENT ANALYSIS


Financial Statement Analysis

  • Annual reports

    • Auditor’s report

    • Director’s report

    • Statement of Financial Performance

      (Income statement)

    • Statement of Financial Position

      (Balance sheet)

    • Cash flow statement


Objectives of Financial Statement Analysis

  • Equity investors

    • Return on capital

    • Capital preservation

  • Credit grantors

    • Short-term – interest cover

    • Long-term – interest cover and capital preservation

  • Management

    • Decision making

    • Control


Objectives of Financial Statement Analysis

  • Employees

    • Job security

    • Wage & salary negotiations

  • Acquisition and merger analysts

    • Valuation of potential candidates

  • Auditors

    • Analytical review

  • Other/Tax authorities

    • Income fairly stated


Statement of Comprehensive Income & Statement of Changes in Equity


Statement of Financial Position


Statement of Cash Flows


Approaches

  • Comparative trend analysis

  • Index analysis

  • Common size analysis

  • Ratio analysis

  • Economic Value Added (EVA)


Approaches continued…

  • Comparative financial statements:

  • Direct comparison of current statements to numerous prior year statements to detect any trends.

  • Index analysis:

  • Similar to comparative method, but a base year is used to express values as percentages for succinct comparisons.


Index analysis

  • The percentages provide a more relatable comparison


Common Size Analysis

  • Statement of Comprehensive Income

  • All line items are expressed as a percentage of Sales Revenue


Application of Ratio Analysis

  • Liquidity ratios

    • Current ratio

    • Quick ratio

  • Asset management ratios

    • Stock (inventory) turnover

    • Average collection period

    • Fixed asset turnover

    • Total asset turnover


Application of Ratio Analysis

  • Debt management ratios

    • Debt ratio

    • Times interest earned

    • Debt equity ratio

  • Profitability ratios

    • Gross profit margin

    • Profit margin

    • Return on total assets

      • EBIT

      • EBIAT

      • Net profit


Application of Ratio Analysis

  • Cash flow ratios

    • Cash flow to total debt

  • Market value ratios

    • Dividend yield

    • Earning yield

    • Price earnings ratio

    • Dividend cover


Liquidity Ratios

  • Current Ratio

    current assets/current liabilities

    • Typical Ltd: 208/120 = 1.73

  • Quick ratio (or acid test ratio)

    (current assets-inventory)/current liabilities

    • Typical Ltd: (208-65)/120 = 1.19


Asset Management Ratios

  • Stock (inventory) turnover

    • Cost of sales / inventory (or sales / inventory)

    • Typical Ltd: 2036/65 = 31.3 times

  • Average collection period

    • Accounts receivable/(sales/365)

    • Typical Ltd: 122/(3573/365) = 12.46 days

  • Fixed asset turnover

    • Sales/fixed assets

    • Typical Ltd: 3573/1227 = 2.91 times

  • Total asset turnover

    • Sales/operating assets

    • Typical Ltd: 3576/(1227 + 208) = 2.49 times


Debt Management Ratios

  • Debt Ratio

    • Debt ratio = total debt/total assets

    • Typical Ltd: (400+120)/(1227+208) = 36.24%

  • Times Interest Earned (TIE)

    • TIE = EBIT/interest

    • Typical Ltd: 282/100 = 2.82 times

  • Debt/Equity Ratio

    • Debt equity = total debt/total equity

    • Typical Ltd: (400+120)/915 = 56.83%


Profitability Ratios

  • Gross Profit Margin

    • GP% = gross profit/sales

    • Typical Ltd: 1537/3573 = 43%

  • Net Profit Margin

    • NP% = net profit /sales

    • Typical Ltd: 282/3573 = 7.89%


Profitability Ratios continued...

  • Return on Assets (NB)

    • ROA = EBIT/Assets

      • Typical Ltd: 282/(1227 + 208) = 19.65%

    • ROA = EBIAT/Assets

      • Typical Ltd: (128 + (100x0.72)/(1227 + 208) = 13.94%

    • ROA = Net profit/Assets

      • Typical Ltd: 128/(1227 + 208) = 8.92%

  • Return on Equity (NB)

    • ROE = Net income / total shareholders’ funds

    • Typical Ltd: 128/915 = 13.99%


Cash Flow Ratios

  • Cash flow to total debt

    Cash flow from operations/total debt

    • Typical Ltd: 219/520 = 42.12%

  • What does this mean?


Market Value Ratios

  • Dividend Yield

    Dividend per share / share price

    • Typical Ltd: 10.6/280 = 3.79%

  • Earnings Yield

    Earnings per share / share price

    • Typical Ltd: 25.6/280 = 9.14%

  • Price-Earnings Ratio

    Share price / earnings per share

    • Typical Ltd: 280/25.6 = 10.94


Market Value Ratios continued...

  • Dividend Cover

    Earnings per share / dividend per share

    • Typical Ltd: 25.6 / 10.6 = 2.42 times

  • Market to Book Ratio

    Share price / NAV per share


Du Pont Analysis

  • Du Pont model

    • ROA = Net profit margin x total asset turnover

  • Modified Du Pont model

    • ROE = ROA x financial leverage multiplier

      ROE = {(earnings/total assets) x (total assets/equity)}

  • Impact of income

  • Impact of activity

  • Impact of capital structure


Du Pont Analysis

  • From Net profit margin to ROE:

  • Notice how the “sales” and “assets” items cancel each other out to leave you with:

    NET PROFIT / EQUITY

  • What is this ratio called?


Failure Prediction

  • Altman’s model – based on NYSE failures

  • De la Rey’s model – based on JSE failures

  • Limitations of MDA (statistical) models

    • Not industry specific

    • Presume no fundamental changes over time

    • Zone of uncertainty exists

  • Altman’s Z” found to be valid for SA companies


Limitations of Ratio Analysis

  • Using industry averages as a benchmark

  • Non standard accounting policies

  • Non standard year-ends

  • Creative accounting

  • Subjective assessment

  • The impact of inflation

  • ROA may be artificially inflated


EVA

  • Economic value added is used for performance measurement

  • Value is created by

    • Improving the return on existing assets

    • Investing in new assets with a return > WACC

    • Selling assets with a return < WACC

    • Reducing the WACC

    • See use of EVA at SABMiller example in book

  • EVA = NOPAT – (c x capital)

  • The PV of expected future EVAs is the MVA


Behind the Numbers

  • Understand the business and the industry sector

  • What are the company’s strategies?

  • Why did Warren Buffet invest in Gillette?

  • Understand management’s motives for selecting accounting policies

  • Loan covenants

  • Management incentives

  • Taxation

  • Regulatory issues


Behind the Numbers continued…

  • Understand the key drivers of value

  • Certain ratios are critical to a specific industry

  • For example: Operating margin in retail

  • Understand which accounting policies are flexible

  • Accounting for leases

  • Operating versus finance leases

  • Off-balance sheet financing


Behind the Numbers continued…

  • Understand the Warning Signs!

  • Increase in accounts receivable that exceeds the increase in sales

  • Increase in inventory that exceeds the increase in sales

  • Restructuring, non-recurring charges and asset write-downs or sales

  • Accounting income and tax losses

  • Accounting income and a negative operating cashflow

  • Complex company structures and related party transactions

  • Accounting policies in relation to research and development, depreciation and leasing


Behind the Numbers continued…

  • Accounting policies that differ from the industry norm

  • Lack of corporate governance

  • Changes in auditors, qualified opinions or published disagreements with the auditor

  • Understand the business and financial risks facing the company

  • Micro and macro factors


Additional Factors to Consider When Analysing a Company

  • Are the directors selling their shares in the company?

  • Is the company aggressive in recognising revenue in relation to long-term contracts?

  • Is the company aggressive about acquisitions?

  • Are the company’s customers performing well?

  • Is the company under litigation?

  • Is the company subject to significant operational risks? Does the company have insurance to cover such risks?


Additional Factors to Consider When Analysing a Company

  • Does the company have actual or potential environmental liabilities? (E.g. mining companies)

  • Are there reports of problems with product quality?

  • Does the company have strong brands?

  • Does the company communicate well with its shareholders and analysts?

  • Is management incentivised to focus on shareholder interests?

  • Is the quality of management superior to other companies in the sector?

  • Does the company make optimal use of Information Technology?

  • Does the company have valuable intangible assets?


Sustainable Growth Rate

SGR = D/E {R – i}p + {R}p

Where:

D = Total debt

E = Total equity

R = ROI = {EBIAT / TA}

i = Average after tax cost of borrowing

p = Percentage of earnings retained


Sustainable Growth Rate


Ratios for South AfricaSource: ABSA


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