Rhys Johnson Head of Education Asia Pacific
Analysis and Interpretation of Financial Statements
Financial statement analysis in perspective Financial statement analysis is only a toolkit within a broader objective of company analysis First of all, need to determine the objective of company analysis To do a proper company analysis, we need to understand the business
Understanding the business The way a company performed is a result of two factors: –the economic and industry environment in which the company operates; and –the company’s own financial characteristics Understanding the business involves financial statement analysis combined with an evaluation of industry prospects, competitive position and corporate strategies Analysis of asset Industry analysis Macroeconomic analysis
Importance of industry prospects Industry attractiveness indicates the likely average profitability of firms in the industry Industry analysis is important because a bad company in a good industry has more upside potential than a good company in a bad industry
Use of financial statement analysis Analyse a single company Mainly interested in financial health and performance Analyse balance sheet –Level of debt –Level of short-term liquidity Analyse P&L Account –Profitability –Ability to service debt cost Using both –Assess efficiency in utilising resources –Assess return on investment eg ROE Common analytical tool – ratios Comparison of companies Comparison of competitors in the same industry –Could use ratios to analyze relative performance and financial attractiveness Comparison of companies in different industries –Depends on objectives –Balance sheet focus –P&L focus –Analyze using actual numbers –Careful when using ratios as companies may not be comparable
Types of ratios Short-term liquidity ratios Finance ratios Performance ratios Investor ratios Ratios for credit analysis
Short-term liquidity ratios Current and quick ratios –measures of short term liquidity –indicate extent to which current assets can pay off current liabilities Current ratio = Current assets Current liabilities Quick ratio = Current assets – Stocks Current liabilities
Finance ratios Balance Sheet: gearing of a company High levels will require high interest payments and will put pressure on the earnings for shareholders Ability to pay interest:
Performance ratios Management and shareholders are interested in the performance of the company Profit and Loss Account is a dynamic statement showing performance over the past year It is therefore used to generate a number of performance metrics
Performance ratios – Profit margins An indicator of the profitability of the business Can be calculated on a gross and net or operating basis Look at profitability on a segmental basis (if available) – by product or geography
Performance ratios – Profit margins Gross profit margin Operating profit margin Gross Profit Margin Gross Profit
Performance ratios – return on capital employed (ROCE)
Interlocking ratios
Investor ratios A number of ratios are used to assess the market performance of a company They are used to try and identify investment opportunities
EPS Price per share = Typical ratios Dividend yield Price earnings ratio Price to sales Price to book value Sales per share Price per share = Book value per share Price per share = = Market price Dividend
Ratios for credit analysis Profitability ratios –Eg: ROE, asset turnover, profit margin Debt and coverage ratios –Short-term liquidity ratios: eg current ratio –Finance ratios –Coverage ratios: eg EBITDA interest coverage, CFO/Total debt ratio
Ratios used in credit rating – Example S&P’s financial ratios across ratings for industrial corporations RatingLeverageCash flows Total debt/CapitalLT debt/CapitalEBIDTA/InterestEBIT/Interest AAA AA A BBB BB B
Limitations of ratio analysis Dependent on the accounting policies adopted Financial statements reflect activities which can be expressed in money terms Financial statements reflect historical information
CASE STUDIES
ACCA membership Exams EthicsExperience
KnowledgeSkillsEssentialsOptions FUNDAMENTALSPROFESSIONAL F1 F2 F3 F4 F5 F6 F7 F8 F9 P1 P2 P3 P4 P5 P6 P7 Financial Reporting