1. FINANCIAL ACCOUNTING a user perspective Sixth Canadian Edition Prepared by: Lynn de Grace C.A. Chapter 12 Financial Statement Analysis

2. Understanding the Business John Wiley & Sons Canada, Ltd. ©2011  You must have a grasp of: Operating activities Underlying economics and risks in the industry Overall strategy followed by the company: Loc cost provider Product/Service differentiator Key success factors crucial to the health of the company 2

3. Understanding the Business John Wiley & Sons Canada, Ltd. ©2011  Read the description of the business in the annual report  Review additional information about the company and the industry  Read the financial statements, including Auditor’s report – Is it an unqualified opinion ? Pay close attention to the notes to the financial statements – especially significant accounting policies of the company 3

4. Retrospective vs. Prospective Analysis John Wiley & Sons Canada, Ltd. ©2011  Make a prospective analysis (forward-looking): Use the past trends to help forecast future outcomes ie. a banker might make a forecast of future cash flows prior to approving a loan;  Do a retrospective analysis to determine past trends: Two major types – times series analysis and cross-sectional analysis This method may be less reliable when something fundamental has changed in the economic environment to make it unlikely that past results will predict the future. 4

5. Time-Series Analysis vs. Cross-Sectional Analysis John Wiley & Sons Canada, Ltd. ©2011 Time-series analysis:  Examines information from different time periods in the life of the company  Looks for patterns in the data over time  Assumes that there is predictability in the time series Cross-sectional analysis:  Compares data from one company to another for the same time period  Usually compares companies in the same industry 5

6. Data To Be Used John Wiley & Sons Canada, Ltd. ©2011  Raw financial data Appear directly in the financial statements Useful in a time-series analysis 6 Socièté BIC Financial Statements

7. John Wiley & Sons Canada, Ltd. ©2011 7 Socièté BIC In millions of euros (except share data)2005 2006200720082009

8. Data To Be Used  Common size data Elements of the raw data are compared with other elements using percentages Common size statement of earnings: All line items are expressed as percentages of net revenues  Common size analysis can also be used with the balance sheet and the cash flow statement John Wiley & Sons Canada, Ltd. ©2011 8 Socièté BIC Financial Statements

9. John Wiley & Sons Canada, Ltd. ©2011 SOCIÈTÉ BIC Common Size Income Statement

10. Ratios John Wiley & Sons Canada, Ltd. ©2011  Ratios Explain the relationships among data in the financial statements Often several ways to calculate a given ratio Useful for making comparisons of data items within a given financial statement General categories: Performance ratios Short-term liquidity ratios Activity ratios Solvency ratios Equity ratios 10

11. Performance Ratios John Wiley & Sons Canada, Ltd. ©2011  Net profit margin  Gross margin  Return on equity (ROE) Measures return to shareholders  Return on assets (ROA) Measures investment in assets 11

12. Performance Ratios  Also known as profitability ratios: Net Profit Margin = Net Earnings Revenues Gross Profit Margin = Gross profit Revenues John Wiley & Sons Canada, Ltd. ©2011 12

13. Performance Ratios John Wiley & Sons Canada, Ltd. ©2011 13

14. Return on Assets John Wiley & Sons Canada, Ltd. ©2011 ROA = Net income + [Interest expense x (1-Tax rate)] Average total assets = Income before interest Average total assets = Net income + [Interest expense - (Tax rate x Interest Expense)] Average total assets 14

15. Return on Assets John Wiley & Sons Canada, Ltd. ©2011 Net income + [Interest expense x (1-Tax rate)] Sales Revenue ROA = Margin x Turnover X Sales Revenue Average Total Assets A useful breakdown of the ROA ratio is: Margin = Turnover = 15

16. Return on Assets John Wiley & Sons Canada, Ltd. ©2011 o ROA ratio excludes the effects of the financing decision (interest expense) and therefore evaluates only the investment decision in assets. o What type of return is earned on assets? o Should be compared to prior years ROA; o Useful to measure performance within the same industry or for projects having similar risk; o Useful to compare cross-sectionally with a direct competitor; o Breakdown into Margin and Turnover ratios provides more detail for the analyst. 16

17. Return on Assets John Wiley & Sons Canada, Ltd. ©2011 17 Note 6 SOCIETE BIC 2009 Annual Report (in thousand euros)Dec 31, 2007Dec 31, 2008Dec 31, 2009 Socièté BIC Financial Statements

18. Return on Assets John Wiley & Sons Canada, Ltd. ©2011 18

19. Return on Assets John Wiley & Sons Canada, Ltd. ©2011 19 MarginXTurnover

20. Return on Equity John Wiley & Sons Canada, Ltd. ©2011 ROE = Net income - Preferred dividends Average common shareholders’ equity o Applies to common shareholders only; o Should be compared with prior years ROE - time series analysis of ROE; o Comparisons must consider differences in risk between companies. 20 Socièté BIC Financial Statements

21. Return on Equity John Wiley & Sons Canada, Ltd. ©2011 21  Determine if there are any aspects of shareholders’ equity that should be excluded from the denominator: Preferred shareholders’ equity Minority interest

22. Leverage John Wiley & Sons Canada, Ltd. ©2011  Financial leverage Leverage is the extent to which a company uses debt to finance itself; Highly leveraged means a larger proportion of debt to equity; When after-tax borrowing rate < ROA, company is successfully using leverage. (debt). At one point, the ceiling for ROE is reached due to increasing risk perceived by lenders. 22 What is Leverage?

23. Leverage  Using the data on Baker Company, we will calculate ROA and ROE under three scenarios: (assume a 40% tax rate) Case A – Company is 100% equity-financed Case B and C – Company is 60% equity-financed and 40% debt financed with a 10% cost of borrowing as follows: John Wiley & Sons Canada, Ltd. ©2011 23

24. Leverage CASE A – 100% Equity-Financed 24 John Wiley & Sons Canada, Ltd. ©2011

25. Leverage John Wiley & Sons Canada, Ltd. ©2011 25 CASE B and C – 60% Equity-Financed

26. Leverage  In Case C, with lower net earnings, the company is not earning an ROA sufficient to cover the cost of borrowing. ROA 4.5% versus after tax cost of borrowing 6%.  This causes ROE to fall below the levels in both Case A and Case B.  The same results could be demonstrated by keeping net earnings at the same level, but raising the cost of borrowing, assuming the company is already heavily leveraged. John Wiley & Sons Canada, Ltd. ©2011 26 CASE A CASE BCASE C ROA9%9%4.5% ROE9%11%3.5%

27. Short-Term Liquidity Ratios John Wiley & Sons Canada, Ltd. ©2011  Refers to a company`s ability to convert assets into cash in order to meet day to day liabilities  Managing the cash cycle is referred to as working capital management  Understanding liquidity requires knowledge of the leads/lags in the company’s cash-to-cash cycle. Current ratio Quick ratio Operating cash flow to short-term debt ratio 27

28. Short-Term Liquidity Ratios John Wiley & Sons Canada, Ltd. ©2011 Current Ratio Current Liabilities Current Assets = Cash + accounts receivable + short- term investments (held for trading) Quick Ratio = Current Liabilities 28

29. Short-Term Liquidity Ratios John Wiley & Sons Canada, Ltd. ©2011 Current short-term debt + current maturities of long-term debt Operating Cash Flow 29 Operating Cash Flow to Short-Term Debt = Socièté BIC Financial Statements

30. Short-Term Liquidity Ratios Socièté BIC (in euros) 20082009 Current Ratio =913,747 = 3.721,208,529 = 3.42 245,683352,867 Quick Ratio = 224,992+18,476+315,108 480,343+40,113+361,172 245,683352,867 = 2.27= 2.50 Cash Flow to Short-term debt =225,104 = 0.92343,140 = 0.97 245,683352,867 John Wiley & Sons Canada, Ltd. ©2011 30

31. Activity Ratios John Wiley & Sons Canada, Ltd. ©2011  Provide measures of the lead/lag relationships that exist between revenue and expense recognition and the related cash flows Total asset turnover Accounts receivable turnover Inventory turnover Accounts payable turnover 31

32. Activity Ratios Total Asset Turnover:  Measures the dollar amount of sales generated for each dollar invested in assets  Important to determine how efficiently the company is using its assets John Wiley & Sons Canada, Ltd. ©2011 32

33. Activity Ratios John Wiley & Sons Canada, Ltd. ©2011 Accounts receivable turnover = Sales on account Average accounts receivable Days to collect= 365 Accounts receivable turnover 33 Accounts Receivable Turnover:  Sometimes necessary to assume all sales are credit sales  Should be compared to company`s credit terms  Large sales at end of reporting period may distort turnover Socièté BIC Financial Statements

34. Activity Ratios John Wiley & Sons Canada, Ltd. ©2011 34

35. Activity Ratios John Wiley & Sons Canada, Ltd. ©2011 Inventory turnover = Cost of Goods Sold Average inventory Days inventory held = 365 Inventory turnover 35 Inventory Turnover:  Tells you how fast inventory is sold, or  How many days, on average, does it take to sell inventory  Has limited use when company does not disclose cost of goods sold separately

36. Activity Ratios John Wiley & Sons Canada, Ltd. ©2011 36

37. Activity Ratios John Wiley & Sons Canada, Ltd. ©2011 Accounts payable turnover = Credit purchases Average accounts payable Days to pay= 365 Accounts payable turnover 37 Accounts Payable Turnover:  Provides information about the company’s payable policy  Cost of goods sold can sometimes replace credit purchases as the numerator  Alternately, can adjust COGS for the change in inventory levels and determine purchases.

38. Activity Ratios John Wiley & Sons Canada, Ltd. ©2011 38

39. Solvency Ratios John Wiley & Sons Canada, Ltd. ©2011  The ability of the company to pay its obligations in the long term  Leverage Ratios: Debt/equity ratio Debt to Total Assets ratio  Coverage Ratios: Times-interest-earned ratio Operating cash flow to total debt ration 39

40. Solvency – Leverage Ratios John Wiley & Sons Canada, Ltd. ©2011 Debt to Equity = Total shareholders’ equity Total liabilities 40  This version of debt to equity expresses the company’s total debt as a percentage of its total shareholders’ equity. Socièté BIC Financial Statements

41. Solvency – Leverage Ratios John Wiley & Sons Canada, Ltd. ©2011 Debt to Total Assets = Total liabilities + shareholders’ equity Total liabilities or = Total Assets Total liabilities 41  This version of debt to equity expresses the portion of the company’s total assets that are financed by debt.

42. Solvency – Leverage Ratios John Wiley & Sons Canada, Ltd. ©2011 42

43. Solvency – Coverage Ratios John Wiley & Sons Canada, Ltd. ©2011 Times- interest- earned = Interest expense (incl. capitalized interest) Income before interest and taxes 43 Times-Interest-Earned Ratio:  Compares the amount of earnings available to pay interest to the level of interest expense  May have to adjust the denominator for capitalized interest – this information would be found in the notes to the financial statements.  This ratio provides comfort to lenders that the company can pay the interest on debt.

44. Solvency – Coverage Ratios John Wiley & Sons Canada, Ltd. ©2011 Operating cash flow to total debt = Total debt Operating cash flow 44 Operating Cash Flow to Total Debt:  Measures the company’s ability to cover its total debt with the annual operating cash flow.  The higher the ratio, the stronger the indication that the company will be able to generate cash and pay off its debts.  Can safely be less than 1, since not all debt will have to be paid off at once.

45. Solvency – Coverage Ratios John Wiley & Sons Canada, Ltd. ©2011 45

46. Equity Ratios John Wiley & Sons Canada, Ltd. ©2011 Basic earnings per share = Weighted average number of common shares outstanding Net income - Preferred dividends 46 Earnings Per Share: Two types must be reported. Fully Diluted Earnings Per Share: Is the amount that earnings per share would become, should all of the dilutive convertible securities were converted to common shares.

47. Equity Ratios  EPS ratio has limited use  Ignores the level of investment in assets – two companies with the same EPS could have very different rates of return  Different numbers of shares outstanding could also cause a difference in EPS when net earnings are similar  EPS applies only to common shareholders – the effects of preferred shares must be removed from the calculation John Wiley & Sons Canada, Ltd. ©2011 47

48. Price/Earnings Ratio John Wiley & Sons Canada, Ltd. ©2011 Price/ earnings = Earnings per share Stock market price per share 48  Compares the price per share on the stock market with the company’s earnings per share  Companies with high growth expectations or low levels of risk will have higher P/E multiples

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