1. Financial Statement Analysis
Mary Low
Waikato Management School
The University of Waikato
© Mary Low

2. 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.
© Mary Low

3. 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.
© Mary Low

4. 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:
Intracompany 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.
© Mary Low

5. 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
© Mary Low

6. 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.
© Mary Low

7. 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
© Mary Low

8. 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
© Mary Low

9. 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
© Mary Low

10. 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
© Mary Low

11. Profitability Ratios Gross Profit % = Gross Profit * 100 Net Sales
Net Profit % = Net Profit after tax * 100
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
Return on Assets = Net Profit * 100
Average Total Assets
Return on Equity = Net Profit *100
Average Total Equity
© Mary Low

12. 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.
© Mary Low

13. 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
© Mary Low

14. 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
© Mary Low

15. 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
© Mary Low

16. 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.
© Mary Low

17. Financial Structure or Capitalisation Ratios
Debt/Equity ratio = Debt / Equity
Debt/Total Assets ratio = Debt *100
Total Assets
Equity ratio = Equity *100
Times Interest Earned = Earnings before Interest and Tax
Interest
© Mary Low

18. 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.
© Mary Low

19. Market Test Ratios Earnings per share = Net Profit after tax
Number of issued ordinary shares
Dividends per share = Dividends
Dividend payout ratio = Dividends per share *100
Earnings per share
Price Earnings ratio = Market price per share
© Mary Low

20. Horizontal analysis/Trend analysis
Trend percentage
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.
© Mary Low

21. Vertical analysis/Common size analysis/ Component Percentages
All items are expressed as a percentage of a common base item within a financial statement
e.g. Financial Performance – sales is the base
e.g. Financial Position – total assets is the base
Important analysis for comparative purposes
Over time and
For different sized enterprises
© Mary Low

22. Limitations of Financial Statement Analysis
We must be careful with financial statement analysis.
Strong financial statement analysis does not necessarily mean that the organisation has a strong financial future.
Financial statement analysis might look good but there may be other factors that can cause an organisation to collapse.
© Mary Low

23. Illustration: Financial statement analysis
The following financial statements of Walker Ltd were prepared in accordance with New Zealand GAAPs. Walker Ltd is a diversified enterprise with its main interests in the manufacture and retail of plastic products.
The financial statements of Walker 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
© Mary Low

24. Walker Ltd Statement of Financial Position as at 31 March
© Mary Low

25. Walker Ltd Statement of Financial Performance for year ended 31 March
© Mary Low

26. Walker Ltd Statement of Cash Flows for the year ended 31 March
© Mary Low

27. Additional information:
Credit purchases for the year 2006 were $2,142,800.
General prospects for the major industries in which Walker 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 Walker Ltd because it is a diversified company. The following are average indicators that relate to the plastic retailing and manufacturing industries for the year 2006.
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%
© Mary Low

28. Profitability ratios:
Relevant ratios
Important note: The calculations of the ratios in this illustration did not use “averages” for total assets, equity and inventory. The 2005 and 2006 year end figures were used and this is a slight variation to the formulas provided.
Profitability ratios:
Benchmarks
2005
2006
Gross Profit Margin
Industry
25%
22%
22.7%
Net Profit Margin 7%
7.1%
6.1%
Return on Assets
12%
15.6%
15.5%
Return on Equity
20%
32%
26%
© Mary Low

29. Asset Management ratios:
Benchmarks
2005
2006
Inventory Turnover
Industry
6 %
5.8 times
5.58 times
Asset Turnover
Not given
2.2
2.53
© Mary Low

30. Credit purchases not available
Liquidity ratios:
Benchmarks
2005
2006
Current Ratio
Ideal standard
2:1
Acceptable standard
1:1
1.78:1
1.70:1
Quick Ratio
0.85:1
0.69:1
Days Payable
Standard
30 days
Credit purchases not available
49.19 days
© Mary Low

31. Financial Structure ratios:
Benchmarks
2005
2006
Debt/Equity
Industry
0.6:1
Standard benchmark
1:1
1.05: 1
0.67:1
TIE
Standard benchmark: Between 3 and 5. Below 3 risky. Above 5 very favourable
10.14 times
39.74 times
© Mary Low

32. 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 2006 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 2006.
© Mary Low

33. Profitability Asset Management
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 unfavourable 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
© Mary Low

34. Liquidity
Current ratios of 1.78:1 (2005) 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 2006 (0.69:1).
Raises some concerns over the liquidity of the business and inventory management (although IT ratio only shows a slight decline in 2006).
Days Payable is a concern as there may be poor debt payment management.
© Mary Low

35. Financial Structure Cash flow situation
Although slightly higher than D/E industry benchmark (0.67:1), business has become less risky due to the significant repayment of loan in 2006.
TIE is extremely good for the business at 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.
© Mary Low

36. 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 Walker Ltd company.
© Mary Low