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CHAPTER 9 Financial statement analysis I. Contents. The purpose of analysis Traditional analysis Tools of analysis Analysing financial statements. The purpose of analysis. Different groups of financial statement users with different information needs

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CHAPTER 9 Financial statement analysis I

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  • The purpose of analysis
  • Traditional analysis
  • Tools of analysis
  • Analysing financial statements
the purpose of analysis
The purpose of analysis
  • Different groups of financial statement users with different information needs
    • Focus will be on needs of equity investors and suppliers of credit
  • Differing levels of technical expertise
    • Focus on tools used by a sophisticated user
the purpose of analysis cont
The purpose of analysis (cont.)
  • Primary questions relate to company performance and financial strength, but user emphasis may differ
    • Investment analysts are primarily interested in financial statements as a predictor of future performance
    • Lenders will primarily focus on the financial strength (default risk)
  • Each question is the sum of different issues
traditional analysis
Traditional analysis
  • Basis of traditional analysis is relevantcomparison
  • Comparison over time or in space
    • Time series analysis: comparing company performance over time
    • Cross-sectional analysis: comparing company performance with other companies in the same industry (or industry average)
time series analysis
Time series analysis
  • Horizontal analysis
  • Using a multi-year information base
  • Trend percentages
    • Select a base year
    • Set item amounts of that year = 100%
    • Corresponding amount of each following year = % of base mount
  • Impact of inflation
cross sectional analysis
Cross-sectional analysis
  • Comparison with other companies in the same industry for the same year
    • Differences in company characteristics should always be accounted for in interpretation
  • Comparison with industry averages
    • Multi-product companies
    • Definition and size of industry groupings
tools of analysis
Tools of analysis
  • Common-size financial statements
  • Use of financial ratios
  • Management performance ratios
  • Financial strength ratios
common size financial statements
Common-size financial statements
  • Standardizing financial statements by introducing a common denominator
  • In a common-size balance sheet each component of the balance sheet is expressed as a percentage of total assets
  • In a common-size income statement each item is expressed as a percentage of sales
common size financial statements cont
Common-size financial statements (cont.)
  • Allow comparison of companies of different size (in terms of total assets and sales)
  • Allow (internal) structural analysis of the financial statements of a company
    • Relative magnitude of asset, liability, equity and income statement components
  • Combination of horizontal and vertical analysis
use of financial ratios
Use of financial ratios
  • A financial ratio expresses the mathematical relationship between two or more financial statement items that are logically linked
  • Comparison over time and in space
    • Like must always be compared with like
  • Combined use of financial ratios is more informative
  • Financial ratios as indicators of management performance and financial strength
management performance ratios
Management performance ratios
  • Profitability and asset utilization ratios
  • Margin ratios (return on sales) show how successful management is in creating profit from a given quantity of sales
  • Return on investment ratios take into account the investment needed to generate the profit
  • Asset utilization ratios measure how efficient management uses the company’s assets
margin ratios
Margin ratios
  • Main ratios:
    • Gross operating margin
    • Net operating margin
    • Net profit margin
  • Measure operating efficiency
  • Tend to be highly industry-specific
return on investment ratios
Return on investment ratios
  • Main ratios:
    • Return on equity (ROE)
    • Return on assets (ROA)
    • Return on capital employed (ROCE)
  • Each reflects the profit generated by a specific pool of funds, excluding the costs of the specific funds considered
  • Different denominators (investment base) and numerators (profit figure retained)
roi perspectives
ROI - perspectives
  • ROE measures how much a company has earned on the funds invested by its shareholders (shareholder perspective)
  • ROA shows how well a company’s funds were used, irrespective of the relative magnitudes of the sources of these funds (current liabilities, debt and equity)
  • ROCE shows how much a company has earned on invested long-term funds (permanently employed capital = equity + LT debt)
figure 9 1 capital employed
Figure 9.1 Capital employed

Capital employed

Capital employed

earnings per share eps
Earnings per share (EPS)
  • Shows how much of a period’s net profit has been earned by each ordinary share outstanding (basic EPS) or by shares outstanding plus all potential shares (diluted EPS)
  • Potential shares are equity instruments issued that can be converted into ordinary shares at the option of the holder of the instrument
  • IAS 33 Earnings per Share requires that listed companies disclose both basic and diluted EPS on the face of the income statement
price earnings ratio
Price/earnings ratio

EPS is used as input to a market ratio, the price/earnings or P/E ratio:

  • Reflects how the market (market price) judges the company’s performance (growth expectations)
  • It is an inverted rate of return ratio
  • Also called the Earnings Multiple
dividend yield ratio
Dividend yield ratio

Thedividend yield ratioreflects the relationship between the dividends per share paid to shareholders and the current market price of a share:

Both P/E and dividend yield ratios of listed companies are published daily by major financial newspapers

asset utilization ratios
Asset utilization ratios
  • Main ratios:
    • Total asset turnover
    • Fixed asset turnover
    • Inventory turnover
    • Receivable turnover
  • Turnover ratios measure efficiency of use of (categories of) assets
  • Tend to be industry-specific
financial strength ratios
Financial strength ratios
  • Indicate the strength of a company’s financial position from the point of view of long-term solvency risk and short-term liquidity risk
  • Solvency refers to the long-term ability to generate cash internally or from external sources in order to meet long-term financial obligations
  • Liquidity refers to the ability to generate cash to meet short-term obligations
long term solvency risk ratios
Long-term solvency risk ratios
  • Main ratios:
    • Debt/equity ratio
    • Gearing ratio
    • Interest and dividend cover
  • Gearing as indicator of default risk
  • Debt financing introduces financial risk because it implies fixed commitments in the form of interest payments and principal repayment and exposure to interest rate movements
short term liquidity risk ratios
Short-term liquidity risk ratios
  • Main ratios:
    • Current ratio and acid-test ratio
    • Credit given and credit obtained
    • Days inventory outstanding
  • Liquidity tests focus on the make-up of working capital and the activity level of its components
  • Low liquidity implies financial risk as inability to service short-term debt payments may lead to higher interest expense and, eventually, bankruptcy
analysing financial statements
Analysing financial statements
  • Decode messages built into financial statements and use them to ‘tell the story’
  • Time series analysis of ratios
  • Combine patterns of financial ratios
  • Compare cross-sectionally
  • Ratio analysis is only part of an investment appraisal process - also consider:
    • Non-financial performance indicators
    • Broader economic variables
    • Information about future business plans, etc.