Statement Analysis - 2 FINANCIAL STATEMENT ANALYSIS Objectives Creditors Short term liquidity Long-term solvency Investors Profitability Dividends Stock price appreciation Prediction of future returns Assessment of risks associated with those returns
Statement Analysis - 3 HORIZONTAL ANALYSIS Percentage changes in comparative statements –(Year to Year comparisons) –Establishment of “Base Period” Trend percentages –Form of horizontal analysis –Series of years –Current year data / Base year data
Statement Analysis - 4 VERTICAL ANALYSIS Relationship of statement items to a specified “Base Item” –Income statement = Net sales –Balance sheet = Total assets
Statement Analysis - 5 COMMON-SIZE STATEMENTS Reports only percentages for statement items “Base Items” normally same as vertical analysis Allows comparison of firms of different size %
Statement Analysis - 6 BENCHMARKING Comparison of a company to standards found in the environment Against Industry Average Against a Major Competitor Against yourself (over time)
Statement Analysis - 7 FINANCIAL STATEMENT RATIOS Objectives Ability to pay current liabilities (Liquidity) Ability to sell inventory and collect receivables (Liquidity / Turnover) Ability to pay long-term debt (Solvency) Profitability of the company Analysis of company’s stock as an investment
Statement Analysis - 8 FINANCIAL STATEMENT ANALYSIS Limitations Statements are largely historical and involve many estimates Comparability between firms may be difficult Financial ratios are only indicators –Specific reasons for problems must still be identified External factors will often impact the financial results of a company Users must look at the entire picture when using financial statement analysis
Statement Analysis - 9 Return on Sales (ROS) A profitability measure Also known as profit margin ratio Considers relative firm size @Cambridge Business Publishers, 2009 Net Income Sales Revenue ROS = = $39,700 $305,000 = 13.0% Cup-A-Jo expects to generate 13 cents of bottom line profit for every dollar of sales revenue.
Statement Analysis - 10 Return on Assets (ROA) A profitability measure Considers relative firm size @Cambridge Business Publishers, 2009 [Net income + Interest expense × (1 – Tax rate)] Total assets ROA = = $39,700 + [$6,300 × (62.3%)] $472,450 = 9.2% Cup-A-Jo has earnings of 9.2% available for its business capital providers. *Effective Tax rate = $24,000/$63,700 = 37.7%
Statement Analysis - 11 Return on Equity (ROE) A profitability measure Also known as return on shareholders’ equity Considers relative firm size @Cambridge Business Publishers, 2009 Net income Shareholders’ equity ROE == $39,700 $371,700 = 10.7% Cup-A-Jo is expected to generate about 10.7 cents of profit for every dollar of shareholders’ investment in the company.
Statement Analysis - 12 Return on Equity Paradigm Reveals four ways to improve ROE 1.Improve return on sales 2.Improve asset turnover 3.Improve use of financial leverage 4.Some combination of 1, 2, and 3 @Cambridge Business Publishers, 2009 Return on Shareholders’ Equity Return on Sales Asset Turnover Financial Leverage
Statement Analysis - 13 Asset Turnover How effective a business’s assets are being used by management to generate sales revenue Key performance indictor @Cambridge Business Publishers, 2009 Sales revenue Total assets Asset Turnover = $305,000 $472,450 = 0.646 For every dollar invested in the company’s assets. Cup-A-Jo generated 64.6 cents of sales. =
Statement Analysis - 14 Financial Leverage Relative mix of debt versus equity financing used by a business @Cambridge Business Publishers, 2009 Total assets Shareholders’ equity Financial Leverage = $472,450 $371,700 = 1.27 Cup-A-Jo’s assets are about 1.27 times the amount of shareholders’ equity invested =
Statement Analysis - 15 Return on Equity for Cup-A-Jo @Cambridge Business Publishers, 2009 Total assets Shareholders’ equity × $472,450 $371,700 1.27 = ROE = Return on Sales × Assets Turnover × Financial Leverage Sales revenue Total assets $305,000 $472,450 0.646 Net income Sales revenue = $39,700 $305,000 = 13.0% ×× × × × = 10.7%
Statement Analysis - 16 Long-term Debt-to-Equity Reveals the relative investment of long- term lenders versus that of shareholders Indicates whether the financing strategy of the company is heavier on debt or equity @Cambridge Business Publishers, 2009 Debt-to- Equity Long-term debt Shareholders’ equity $67,500 $371,700 = 0.182== Cup-A-Jo’s long-term debt is about 18% of the amount of shareholders’ equity.
Statement Analysis - 17 Times-Interest-Earned Ratio Reveals the extent to which operating earnings is able to ‘cover’ current debt service charges (interest) @Cambridge Business Publishers, 2009 Interest Coverage Operating income Interest expense $70,000 $6,300 = 11.1 = = Cup-A-Jo’s operating income is able to cover interest about 11 times per year.