FINANCIAL STATEMENT ANALYSIS UNIT 12

Analysing financial statements involves evaluating three characteristics of a company: 1. its liquidity 2. its profitability 3. its solvency BASICS OF FINANCIAL STATEMENT ANALYSIS

COMPARATIVE ANALYSIS Three types of comparisons: –Intracompany basis-compare previous years data with current year within the company. –Intercompany basis – compare data with specific competitors. –Industry averages - compare overall industry data.

COMPARATIVE ANALYSIS Three tools: –Horizontal analysis –Vertical analysis –Ratio analysis

HORIZONTAL ANALYSIS 127%121%119%112%100% ANY COMPANY INC. Assumed Net Sales For the Year Ended December 31 (in millions) $ 6,562.8$ 6,295.4$ 6,190.6$ 5,786.6$ 5,181.4 Change since base period

VERTICAL ANALYSIS VERTICAL ANALYSIS Expresses each item in a financial statement as a percent of a base amount (total assets or net sales) ANY COMPANY, INC. Condensed Balance Sheets (Partial) December 31 (in millions) AssetsAmountPercent AmountPercent Current assets$1, $1, Capital assets 2, , Other assets Total assets$5, % $4, %

VERTICAL ANALYSIS VERTICAL ANALYSIS

RATIO ANALYSIS Liquidity Ratios Measure short-term ability of the enterprise to pay its maturing obligations and to meet unexpected needs for cash. Profitability Ratios Measure the income or operating success of an enterprise for a given period of time. Solvency Ratios Measure the ability of the enterprise to survive over a long period of time. Ratios may be expressed as percentages (50%), proportions (1:2), Days (32 days), or rate (3.23)

LIQUIDITY RATIOS LIQUIDITY RATIOS Current ratio Acid test ratio Receivables turnover Collection period Inventory turnover Days sales in inventory

CURRENT RATIO Measures short-term debt-paying ability Current ratio =Current assets Current liabilities (Discussed in Chapter 4)

ACID TEST RATIO Measures immediate short-term debt- paying ability Acid test ratio = Cash + temporary investments + net receivables Current liabilities (Discussed in Chapter 9)

RECEIVABLES TURNOVER Measures liquidity of receivables Receivables turnover = Net credit sales Average net receivables (Discussed in Chapter 9)

COLLECTION PERIOD Measures number of days receivables are outstanding Collection period = 365 days Receivables turnover (Discussed in Chapter 9)

INVENTORY TURNOVER INVENTORY TURNOVER Measures liquidity of inventory Inventory turnover = Cost of goods sold Average inventory (Discussed in Chapter 5)

DAYS SALES IN INVENTORY Measures number of days inventory is on hand Days in inventory = 365 days Inventory turnover (Discussed in Chapter 5)

PROFITABILITY RATIOS Profit margin Gross profit margin Return on assets Return on common shareholders’ equity Book value per share Earnings per share (EPS) Price-earnings (PE) ratio Dividend yield

PROFIT MARGIN Measures net income generated by each dollar of sales (Discussed in Chapter 5) Profit margin = Net income Net sales

GROSS PROFIT MARGIN Measures margin between selling price and cost of goods sold generated by each dollar of sales (Discussed in Chapter 5) Gross profit margin = Gross profit Net sales

RETURN ON ASSETS Measures overall profitability of assets Return on assets = Net income Average total assets (Discussed in Chapter 10)

RETURN ON COMMON SHAREHOLDERS’ EQUITY Measures profitability of common shareholders’ investment Return on common shareholders’ equity = Net income Average common shareholders’ equity (Discussed in Chapter 14)

BOOK VALUE PER SHARE Measures the equity (net assets) per common share Book value per share = Common shareholders’ equity Number of common shares (Discussed in Chapter 14)

EARNINGS PER SHARE (EPS) Measures net income earned on each common share (Discussed in Chapter 15) Earnings per share = Net income Number of common shares

PRICE-EARNINGS (PE) RATIO Measures relationship between market price per share and earnings per share (Discussed in Chapter 15) Price-earnings ratio = Share price Earnings per share

DIVIDEND YIELD Measures rate of return earned from dividends (Discussed in Chapter 15) Dividend yield = Cash dividends per share Share price

SOLVENCY RATIOS SOLVENCY RATIOS Debt to total assets Cash total debt coverage

DEBT TO TOTAL ASSETS Measures % of total assets provided by creditors Debt to total assets = Total liabilities Total assets (Discussed in Chapter 16)

CASH TOTAL DEBT COVERAGE Measures long-term debt-paying ability (cash basis) Cash total debt coverage ratio = Net cash provided by operating activities Average total liabilities (Discussed in Chapter 18)

Estimates Historical cost Alternative accounting methods Atypical data Diversification LIMITATIONS OF FINANCIAL ANALYSIS