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### Chapter 6

Financial Statement Analysis

Objectives of Financial Statement Analysis

- Understand reported financial data
- Better manage a business
- Provide a base for rational decision making (though the major focus of separate analyses and types of decision under consideration will vary)
- Make a reasonable assessment of future financial condition based on present and past financial conditions and on best available estimate of future economic occurrences

Objectives of Financial Statement Analysis

- Why not accept prepared financial statements at face value?
- Prepared financial statements require some analysis as first step toward extracting information from presented data.
- Decisions made on basis of financial analysis are important and accepting presented financial data at face value is poor policy.

Ratio Analysis

- Ratio analysis: financial ratios are used to develop a set of statistics that reveal key financial characteristics of a company
- Ratios are compared with industry standards.
- Some industry standards can be obtained through commercial services (i.e. Dun and Bradstreet, Robert Morris Associates) or through industry trade services.
- Analysts may have to develop their own standards by calculating average ratios for leading companies in same industry.
- Ratios are used to analyze the trend over time for a particular company.
- Track key ratios through previous one or two economic recessions to determine company’s financial strength during periods of economic adversity

Ratio Analysis

- Four major categories of key financial ratios:
- Profitability: “bottom-line” ratios designed to measure earning power and profitability record of company
- Liquidity: ratios designed to measure ability of firm to meet its short-term liabilities as they come due
- Operating efficiency: measures of efficiency with which corporate resources are employed to earn profit
- Capital structure (leverage): measures of extent to which debt financing is employed by company

Ratio Analysis

- Profitability:
- Return on sales (ROS)
- Return on assets (ROA)
- Return on equity (ROE)

Ratio Analysis

- Profitability
- Return on sales (ROS or net margin)
- Net sales: dollar volume of sales less any returns, allowances, and cash discounts

Earnings after tax

Net sales

ROS =

Ratio Analysis

- Profitability

2. Return on assets (ROA or return on total assets (ROTA) or return on investment (ROI)):

Earnings after tax

Total assets

ROA =

Ratio Analysis

- Profitability
- Return on equity (ROE):
- Measures owner’s invested capital
- Stockholder’s equity: determined by deducting total liabilities and intangible assets from total assets
- Excludes effect of any intangible assets (i.e. goodwill, trademarks)
- ROE of at least 15% is a reasonable objective to provide adequate dividends and to fund future growth.

Earnings after tax

Stockholder’s equity

ROE =

Ratio Analysis

- Liquidity:
- Current ratio
- Quick ratio
- Average collection period
- Days sales in inventory

Ratio Analysis

- Liquidity
- Current ratio:
- Current assets: cash, marketable securities, accounts receivable, and inventories
- Current liabilities: accounts payable, current notes payable, and currently due portion of any long-term debt

Current assets

Current liabilities

Current ratio =

Ratio Analysis

- Liquidity
- Quick ratio (“acid test”):
- For bankers and other lenders, ratio should be at least 1 to 1.
- Quick assets (current assets net of inventories): assets that can be quickly converted to cash

Cash + Marketable securities + Accounts receivable

Current liabilities

Quick ratio =

Ratio Analysis

- Liquidity
- Average collection period: measures the speed with which receivables are turned into cash
- should not exceed net maturity indicated by firm’s selling terms by more than 10-15 days

Net sales

365 days

Average daily sales =

Accounts receivable

Average daily sales

Average collection period =

Ratio Analysis

- Liquidity
- Days sales in inventory:
- Net sales used in numerator, which represents cost of goods sold plus gross profit margin
- Not a good measure of physical turnover
- Provides important benchmark against which to compare ratio of sales dollars to inventory stocks of one business to that of another and how efficiently management is using its inventory resources to support sales

Inventory

Average daily sales

Days sales in inventory =

Ratio Analysis

- Operating efficiency ratios: measure the relationship between annual sales and investments in various classes of asset accounts
- Cost of goods sold to inventory
- Sales to total assets
- Sales to working capital

Ratio Analysis

- Operating efficiency ratios
- Cost of goods sold to inventory: provides estimate of physical turnover rates
- Numerator measures how efficiently inventory is being managed

Cost of goods sold

Inventory

Cost of sales to inventory =

Ratio Analysis

- Operating efficiency ratios
- Sales to total assets: measures relationship between sales and assets used to support those sales
- Often used to compare structure and capital requirements of different industries

Net sales

Total assets

Sales to total assets =

Ratio Analysis

- Operating efficiency ratios
- Sales to working capital:
- Recall:
- Working capital = Current assets – current liabilities

Net sales

Working capital

Sales to working capital =

Ratio Analysis

- Capital structure (leverage) ratios
- Leverage: extent to which firm employs debt capital to finance its operations
- The more debt employed by firm, the more highly leveraged it is said to be.
- Debt ratio
- Long-term debt to total assets
- Debt equity ratio
- Times interest earned ratio

Ratio Anaylsis

- Capital structure ratios
- Debt ratio: measures relationship between total assets and amount of debt used to finance those assets

Total debt

Total assets

Debt ratio =

Ratio Analysis

- Capital structure ratios
- Long-term debt to total assets: measures percentage of total assets that is financed by long-term debt

Long-term debt

Total assets

Long-term debt/Total assets ratio =

Ratio Analysis

- Capital structure ratios
- Debt equity ratio: measures relationship between capital supplied by lenders (debt) and capital supplied by owners (equity)

Total debt

Equity

Debt equity ratio =

Ratio Analysis

- Capital structure ratios
- Times interest earned ratio:
- Computed as ratio of earnings before interest and taxes (EBIT) to interest expense
- EBIT = Earnings after tax + Interest expense + Income tax

Earnings before interest and taxes

Interest expense

Times interest earned =

Ratio Analysis

- Interrelationships Among Ratios
- Firm’s profitability, liquidity position, operating efficiency, and leverage position are all interrelated.

Ratio Analysis

- DuPont system of analysis: relates return on investment to firm’s profit margin and asset turnover
- ROA results from interaction of firm’s profit margin (net income/sales) and asset turnover (sales/total assets)
- ROA = margin x turnover
- ROA is an overall performance measure of profitability (profit margin) and its operating efficiency (total asset turnover)

Net income

Total assets

Net income

Sales

__Sales__

Total assets

x

=

Ratio Analysis

- Relationships among ROE, ROA and leverage position
- The higher the firm’s leverage (ratio of total assets to stockholders’ equity), the higher will be its ROE relative to ROA.
- Equity multiplier: measure of leverage used to show that use of debt (leverage) is reflected in an increasing ratio of assets to equity because use of debt allows firm to add assets without increasing equity

Net income

Stockholder’s equity

Net income

Sales

Sales

Total assets

=

X

Ratio Analysis

- Computation and display of a set of ratios for a given company in a given year is of limited usefulness by itself….
- Ratios must be compared to performance in other years and to appropriate standards for companies of approximately equal asset size in similar industries.

Common-Size Statements

- Common-size financial statement: expresses all accounts on balance sheet and income statement as a percentage of some key figure

Common-Size Statements

- Common-size balance sheet
- Analyzes internal structure and allocation of firm’s financial resources
- Asset side shows how investments in various financial resources are distributed among asset accounts
- Liabilities and equities side shows percentage distribution of financing provided by current liabilities, long-term debt, and equity capital

Common-Size Statement

- Common-size income statement
- Shows proportion of sales or revenue dollar absorbed by various cost and expense items

Sequence of Analysis

- Main objective of analysis determines relative degree of emphasis to place on each area of analysis (profitability, liquidity, operating efficiency, or capital structure)
- But one logical framework can be employed to systematically explore financial health of organization…

Sequence of Analysis

- Specify clearly objectives of analysis and develop set of key questions that should be answered to attain this objective
- Prepare data (i.e. key ratios and common-size statements) necessary to work toward specified goals

Sequence of Analysis

- Analyze and interpret numerical information developed in prepared data
- First examine information provided by ratio analysis in order to develop overall feel for potential problem areas
- Then use preliminary questions and opinions developed during analysis of ratio data to focus on information contained in common-size statements

Sequence of Analysis

- Form conclusions based on data and answer questions posed in Step 1
- Present specific recommendations, backed up by available data, along with brief summary of major points developed previously
- Begin written report with summary of conclusions developed in this final phase

Case Study – Technosystems, Inc.

- Technosystems: 3-year-old, privately owned company engaged in wholesale distribution of plumbing, heating, and air conditioning
- President: John Diamond
- Walker Equipment Company: company specializing in sale and leasing of heavy construction equipment
- President: David Walker
- CPA: Carla Gilberti

Case Study – Technosystems, Inc.

- David and Carla had no interest in operating a new company, but they agree to become equal partners in financing Technosystems if John would start up and manage it.
- Technosystems was originally financed with a $100,000 loan from David and Carla, payable in ten annual installments of $10,000 plus 14% interest on declining balance.

Case Study – Technosystems, Inc.

Key Financial Ratios - See exhibit 6.3

- Technosystems is undercapitalized
- Debt ratio is extremely high
- Total debt is equal to almost 80% of total assets, compared with industry standard of 50%
- Long-term debt is equal to nearly 30% of total assets, almost double industry standard of 15%
- Debt is private debt loaned to company by two of its partners

Case Study – Technosystems, Inc.

Key Financial Ratios - See exhibit 6.3

- Profitability ratios
- Overall level and trend of earnings looks positive
- ROS is just below industry average of 3.5%, and shows rapidly increasing trend
- ROA is increasing rapidly and above industry average
- ROE is extremely high due mainly to high debt position and low equity relative to debt

Case Study – Technosystems, Inc.

Key Financial Ratios - See exhibit 6.3

- Profitability ratios (continued)
- ROA has improved as result of improvement in both ROS ratio and asset turn over ratio:
- ROA = (Profit margin) x (Asset turnover)
- ROA (2008)= (3.34%) x (4.5) = 15.0%
- ROA (2007) = (2.10%) x (3.6) = 7.5%
- High rate of ROE of 68.1% is result of high debt position:
- ROE = (ROA) x (Total assets/Equity)
- ROE = (15.03%) x ($284,100/$62,700) = (15.03%) x (4.53) = 68.1%
- The higher this ratio, the more debt used

Case Study – Technosystems, Inc.

Key Financial Ratios - See exhibit 6.3

- Liquidity ratios
- Current ratio is below industry average
- Quick ratio is approximately equal to industry average
- Average collection period is well below industry average (indicates that company is doing excellent job of collecting its receivables)
- Inventory control (below-average days sales in inventory number) is excellent

Case Study – Technosystems, Inc

Key Financial Ratios - See exhibit 6.3

- Operating efficiency ratios
- Inventory turnover (cost of sales to inventory ratio), sales to total assets, and sales to working capital ratios are all above industry averages

Case Study – Technosystems, Inc.

Common-Size Analysis

- Common-size balance sheet (see exhibit 6.4)
- Fixed assets as percentage of total assets have increased since 2001
- Increase in retained earnings account and hence total equity as percent of total assets
- Sharp decrease in percentage of total assets financed by current liabilities and long-term debt
- Within working capital accounts, there is steady decrease in total current assets as percent of total assets

Case Study – Technosystems, Inc.

Common-Size Analysis

- Common-size income statement (see exhibit 6.5)
- From 2006 to 2008, steady improvements:
- Gross profit margin has increased from 18.9% to 25.4%
- Pre-tax margin has increased from 0.1% to 5.6%
- After-tax margin has increased from 0.1% to 3.3%
- Total expenses as percent of sales have remained relatively steady and only increased from 18.9% to 19.8%

Case Study – Technosystems, Inc.

Technosystems Conclusions

- Profitability is excellent and improving.
- Liquidity position is strong and improving.
- Technosystems carries a heavy debt load.
- Liquidation is unlikely since lenders are two of the founders
- Repayment of loans is likely since operating efficiency ratios reflect sound management and profitability is growing

Financial Analysis, Financial Fraud and Financial Stress

- Enron and Worldcom were two of the largest corporate bankruptcies related to allegations of widespread fraud, cover-ups, and criminal behavior by senior executives of these corporations and their auditors.
- Massive fraud on this scale are now exception due to increased public scrutiny, but there are new risks and problems due to combination of excessive leverage, bad real estate deals, under-provisioning for loan, insurance or derivative losses and/or bad management

Financial Analysis, Financial Fraud and Financial Stress

- New regulations will likely prohibit:
- Leverage ratios greater than 30 to 1
- Ability of homeowners to borrow all or more than all of value of equity in their homes
- Unregulated writing of credit default swaps without appropriate insurance reserves (accounting for concentration of risk)

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