BY H ONDIGO SCHOOL OF BUSINESS UNIVERSITY OF NAIROBI 2012 TOOLS OF FINANCIAL STATEMENT ANALYSIS
Presentation Objectives • Explain business analysis and its relation to financial statement analysis • Identify and discuss different types of business analysis • Describe the component analysis • Learn the sources of financial information • Identify and describe the common tools of Financial analysis • Define EMH and State implications for Analysis
Business Environment & Strategy Analysis Industry Analysis Strategy Analysis Prospective Analysis Accounting Analysis Financial Analysis Analysis of Sources &Uses of Funds Risk Analysis Profitability Analysis Cost of Capital Estimate Intrinsic Value
Business Analysis • Business analysis is the evaluation of a company’s prospects & risks for the purpose of making business decision • Business Decision Makers include: • Equity Investors • Creditors • Managers • Merger and Acquisition Analysis • External Auditors • Directors • Regulators • Employees and Unions
Accounting Analysis Process to evaluate and adjust financial statements to better reflect economic reality Comparability problems — across firms and across time Manager estimation error Distortion problems Earnings management Distortion of business Accounting Risk
Strategy Analysis • The purpose of Business Strategy Analysis Identify key profit drives and business risks Assess company’s profit potential at a qualitative level • Strategy Analysis involves Industry analysis Competitive strategy Corporate strategy analysis
Industry Analysis Analyzing a firm’s profit potential must first assess industry profitability. It includes: • Degree of actual and potential competition (1) Rivalry among existing firms (2) Threat of new entrants (3) Threat of substitute products • Bargaining power in input and output markets (1) Bargaining power of buyers (2) Bargaining power of suppliers
Competitive strategy analysis Competitive strategy analysis is the evaluation of a company’s decisions and success at establishing a competitive advantages • Cost leadership: supply same product and service at the lower cost • Differentiation: supply a unique product or service at a cost lower than the price premium customers will pay
Corporate strategy analysis • Involves examining whether a company is able to create value in multiple businesses • A well-crafted corporate strategy reduces costs or increase revenues from running several businesses in one firm. • Cost saving or revenue increases come from specialized resources that the firm has to exploit synergies across these businesses
Financial (Statement) Analysis • Financial statement analysis is the process of analyzing financial information to predict the future financial performance and condition • An important part of business analysis • Provide a systematic and effective statement analysis • Reliable inferences are drawn about a company prospects and risks
Financial (Statement) Analysis Process to evaluate financial position and performance using financial statements Profitability analysis—Evaluate return on investments Risk analysis ——— Evaluate riskiness & creditworthiness Sources and uses —Evaluate source & of funds analysis deployment of funds Common tools Ratio analysis Cash flow analysis
Prospective Analysis Process to forecast future payoffs Business Environment & Strategy Analysis Accounting Analysis Financial Analysis Intrinsic Value
Sources of Financial Information • Principle financial statements include: • The Statement of financial Position (balance sheet) • The statement of income • The statement of cash flow • The statement of stockholders’ equity • Notes to the financial statements • Auditor’s report • Management discussion and analysis • Other data sources: Chairperson’s letter, Finance press, Web sites, Industry statistics, Economic indicators • .
Business Survival There are two key factors for business survival: • Profitability • Solvency • Profitability is important if the business is to generate revenue (income) in excess of the expenses incurred in operating that business. • The solvency of a business is important because it looks at the ability of the business in meeting its financial obligations.
Financial Statement Analysis • Financial Statement Analysis will help business owners and other interested people to analyse the data in financial statements to provide them with better information about such key factors for decision making and ultimate business survival.
Financial Statement Analysis Purpose: • To use financial statements to evaluate an organisation’s • Financial performance • Financial position. • To have a means of comparative analysis across time in terms of: • Intra-company basis (within the company itself) • Intercompany basis (between companies) • Industry Averages (against that particular industry’s averages) • To apply analytical tools and techniques to financial statements to obtain useful information to aid decision making.
Financial Statement Analysis Financial statement analysis involves analysing the information provided in the financial statements to: • Provide information about the organisation’s: • Past performance • Present condition • Future performance • Assess the organisation’s: • Earnings in terms of power, persistence, quality and growth • Solvency
Effective Financial Statement Analysis • To perform an effective financial statement analysis, you need to be aware of the organisation’s: • business strategy • objectives • annual report and other documents like articles about the organisation in newspapers and business reviews. These are called individual organisational factors.
Effective Financial Statement Analysis Requires that you: • Understand the nature of the industry in which the organisation works. This is an industry factor. • Understand that the overall state of the economy may also have an impact on the performance of the organisation. → Financial statement analysis is more than just “crunching numbers”; it involves obtaining a broader picture of the organisation in order to evaluate appropriately how that organisation is performing
Tools of Financial Statement Analysis: The commonly used tools for financial statement analysis are: • Financial Ratio Analysis • Comparative financial statements analysis: • Horizontal analysis/Trend analysis • Vertical analysis/Common size analysis/ Component Percentages • Cash Flow Analysis • Valuation
Financial Ratio Analysis • Financial ratio analysis involves calculating and analysing ratios that use data from one, two or more financial statements. • Ratio analysis also expresses relationships between different financial statements. • Financial Ratios can be classified into 5 main categories: • Profitability Ratios • Liquidity or Short-Term Solvency ratios • Asset Management or Activity Ratios • Financial Structure or Capitalisation Ratios • Market Test Ratios
Profitability Ratios 3 elements of the profitability analysis: • Analysing on sales and trading margin • focus on gross profit • Analysing on the control of expenses • focus on net profit • Assessing the return on assets and return on equity
Profitability Ratios • Gross Profit % = Gross Profit * 100 Net Sales • Net Profit % = Net Profit after tax * 100 Net Sales Or in some cases, firms use the net profit before tax figure. Firms have no control over tax expense as they would have over other expenses. • Net Profit % = Net Profit before tax *100 Net Sales • Return on Assets = Net Profit * 100 Average Total Assets • Return on Equity = Net Profit *100 Average Total Equity
Liquidity or Short-Term Solvency ratios Short-term funds management • Working capital management is important as it signals the firm’s ability to meet short term debt obligations. For example: Current ratio • The ideal benchmark for the current ratio is $2:$1 where there are two dollars of current assets (CA) to cover $1 of current liabilities (CL). The acceptable benchmark is $1: $1 but a ratio below $1CA:$1CL represents liquidity riskiness as there is insufficient current assets to cover $1 of current liabilities.
Liquidity or Short-Term Solvency ratios • Working Capital = Current assets – Current Liabilities • Current Ratio = Current Assets Current Liabilities • Quick Ratio = Current Assets – Inventory – Prepayments Current Liabilities – Bank Overdraft
Asset Management or Activity Ratios • Efficiency of asset usage • How well assets are used to generate revenues (income) will impact on the overall profitability of the business. For example: Asset Turnover • This ratio represents the efficiency of asset usage to generate sales revenue
Asset Management or Activity Ratios • Asset Turnover = Net Sales Average Total Assets • Inventory Turnover = Cost of Goods Sold Average Ending Inventory • Average Collection Period = Average accounts Receivable Average daily net credit sales* * Average daily net credit sales = net credit sales / 365
Financial Structure or Capitalisation Ratios Long term funds management • Measures the riskiness of business in terms of debt gearing. For example: Debt/Equity • This ratio measures the relationship between debt and equity. A ratio of 1 indicates that debt and equity funding are equal (i.e. there is $1 of debt to $1 of equity) whereas a ratio of 1.5 indicates that there is higher debt gearing in the business (i.e. there is $1.5 of debt to $1 of equity). • This higher debt gearing is usually interpreted as bringing in more financial risk for the business particularly if the business has profitability or cash flow problems.
Financial Structure or Capitalisation Ratios • Debt/Equity ratio = Debt / Equity • Debt/Total Assets ratio = Debt *100 Total Assets • Equity ratio = Equity *100 Total Assets • Times Interest Earned = Earnings before Interest and Tax Interest
Market Test Ratios • Based on the share market's perception of the company. For example: Price/Earnings ratio • The higher the ratio, the higher the perceived quality of the earnings by the share market.
Market Test Ratios • Earnings per share = Net Profit after tax Number of issued ordinary shares • Dividends per share = Dividends Number of issued ordinary shares • Dividend payout ratio = Dividends per share *100 Earnings per share • Price Earnings ratio = Market price per share Earnings per share
Illustration: Financial statement analysis • The following financial statements of Hifadhi Ltd were prepared in accordance with IFRSs. Hifadhi Ltd is a diversified enterprise with its main interests in the manufacture and retail of plastic products. • The financial statements of Hifadhi Ltd need to be analysed. An investor is considering purchasing shares in the company. Relevant ratios need to be selected and calculated and a report needs to be written for the investor. The report should evaluate the company’s performance and position
Additional information: • Credit purchases for the year 2012 were $2,142,800. • General prospects for the major industries in which Hifadhi is involved look good with a forecast glut of oil set to reduce the cost of production and world demand for plastic remaining strong. Benchmarks: • There are no exact benchmarks for Hifadhi Ltd because it is a diversified company. The following are average indicators that relate to the plastic retailing and manufacturing industries for the year 2012. • Gross profit margin 25% • Net profit margin 7% • Inventory turnover 6 times • Debt/equity ratio 0.6 : 1 • Return on Assets 12% • Return on Equity 20%
Relevant ratios Important note: The calculations of the ratios in this illustration did not use “averages” for total assets, equity and inventory. The 2011 and 2012 year end figures were used and this is a slight variation to the formulas provided.
The Report • For the investor considering the purchase of shares in the company, the return they will earn is the key financial factor but an overall evaluation of the company’s performance and position is also important to get a better picture of how well the company is actually doing. • ROE in 2012 is 26%. Whether or not this is attractive depends on the perceived riskiness of this investment and other alternatives available but this return is certainly more attractive than current bank interest rates. • ROE has decreased by 4% but the company’s ROE at 26% is still better than the industry average of 20% • Riskiness of business is being reduced by the significant repayment of loan in 2012.
The Report cont… • Profitability • The NP% and ROA ratios show a small downward trend in % over the 2 year period. ROE% ratio show a more significant decrease but is still better than the industry average. • Gross Profit Margin is slightly unfavorable at about 2.3% below the industry benchmark of 25%. • The horizontal analysis information show that Sales have increased by 20%. However operating costs have increased by 34%. • Asset Management • IT has gone down slightly from 5.8 to 5.58 times. • IT is still close to the industry benchmark of 6 times. • AT has increased showing more sales being generated from asset usage
The Report cont… • Liquidity • Current ratios of 1.78:1 (2011) and 1.70: 1 are at above acceptable levels but below ideal level. • Quick ratios appear more of a concern being below acceptable levels in both years and even more so in 2012 (0.69:1). • Raises some concerns over the liquidity of the business and inventory management (although IT ratio only shows a slight decline in 2012). • Days Payable is a concern as there may be poor debt payment management.
The Report cont… • Financial Structure • Although slightly higher than D/E industry benchmark (0.67:1), business has become less risky due to the significant repayment of loan in 2012. • TIE is extremely good for the business at 39.74 times (well above 5 the standard benchmark). • Cash flow situation • Strong cash flow from operating activities (increased from 160,600 to 185,000). • Spending under investing activities suggest more growth. • Repayment of debt under financing activities imply restructuring of business to have more equity funding rather than debt funding.
Recommendation Given: • The strong forecast for the industry (ie general prospects looking good and world demand for plastic products remaining strong), • The sales growth in this business, • Acceptable ratios as they are quite close to the industry averages, • Good cash flows from operating activities and • Favourable ROE, although it has decreased, it is still better than the industry average ROE. => it is recommended that the investor purchase shares in the Hifadhi Ltd company.
Comparative/Horizontal Financial Statement Analysis • This involves reviewing consecutive financial statements from period to period. • It usually involves a review of changes in individual account balances on a year to year or a multi year basis. • The most important information revealed by the analysis is the trend. • For example a 10% increase in sales accompanied by a 20 % in cost of sales or selling expenses may require investigation and explanation. Similarly a 30% increase in receivables accompanied by a sales increase of 10% calls for investigation. • Two comparative analysis techniques include: • Year to year change analysis • Index number/ Trend analysis
Trend (percentage) analysis • Line-by-line item analysis • Items are expressed as a percentage of a base year • This is a time series analysis • For example, a line item could look at increase in sales turnover over a period of 5 years to identify what the growth in sales is over this period.
Comparative Analysis Yr1 Yr2 Yr3 Purpose: Evaluation of consecutive financial statements Output: Direction, speed, & extent of any trend(s) Types: Year-to-year Change Analysis Index-Number Trend Analysis
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