1. CHAPTER 9 Financial statement analysis I

2. Contents The purpose of analysis Traditional analysis
Tools of analysis
Analysing financial statements

3. The purpose of analysis
Different groups of financial statement users with different information needs
Focus will be on needs of equity investors and suppliers of credit
Differing levels of technical expertise
Focus on tools used by a sophisticated user

4. The purpose of analysis (cont.)
Primary questions relate to company performance and financial strength, but user emphasis may differ
Investment analysts are primarily interested in financial statements as a predictor of future performance
Lenders will primarily focus on the financial strength (default risk)
Each question is the sum of different issues

5. Traditional analysis
Basis of traditional analysis is relevant comparison
Comparison over time or in space
Time series analysis: comparing company performance over time
Cross-sectional analysis: comparing company performance with other companies in the same industry (or industry average)

6. Time series analysis Horizontal analysis
Using a multi-year information base
Trend percentages
Select a base year
Set item amounts of that year = 100%
Corresponding amount of each following year = % of base mount
Impact of inflation

7. Time series analysis- Illustration
Trend percentages of total sales (2000 = 100%)
2005
2004
2003
2002
2001
2000
Sales (€million)
617
583
492
413
627
445
Sales –
trend %
139%
131%
111%
93%
141%
100%

8. Cross-sectional analysis
Comparison with other companies in the same industry for the same year
Differences in company characteristics should always be accounted for in interpretation
Comparison with industry averages
Multi-product companies
Definition and size of industry groupings

9. Tools of analysis Common-size financial statements
Use of financial ratios
Management performance ratios
Financial strength ratios

10. Common-size financial statements
Standardizing financial statements by introducing a common denominator
In a common-size balance sheet each component of the balance sheet is expressed as a percentage of total assets
In a common-size income statement each item is expressed as a percentage of sales

11. Common-size financial statements (cont.)
Allow comparison of companies of different size (in terms of total assets and sales)
Allow (internal) structural analysis of the financial statements of a company
Relative magnitude of asset, liability, equity and income statement components
Combination of horizontal and vertical analysis

12. Common-size balance sheet - Illustration

13. Common-size income statement - Illustration

14. Use of financial ratios
A financial ratio expresses the mathematical relationship between two or more financial statement items that are logically linked
Comparison over time and in space
Like must always be compared with like
Combined use of financial ratios is more informative
Financial ratios as indicators of management performance and financial strength

15. Management performance ratios
Profitability and asset utilization ratios
Margin ratios (return on sales) show how successful management is in creating profit from a given quantity of sales
Return on investment ratios take into account the investment needed to generate the profit
Asset utilization ratios measure how efficient management uses the company’s assets

16. Table 9.1 Profitability ratios

17. Margin ratios Main ratios: Measure operating efficiency
Gross operating margin
Net operating margin
Net profit margin
Measure operating efficiency
Tend to be highly industry-specific

18. Return on investment ratios
Main ratios:
Return on equity (ROE)
Return on assets (ROA)
Return on capital employed (ROCE)
Each reflects the profit generated by a specific pool of funds, excluding the costs of the specific funds considered
Different denominators (investment base) and numerators (profit figure retained)

19. ROI - perspectives
ROE measures how much a company has earned on the funds invested by its shareholders (shareholder perspective)
ROA shows how well a company’s funds were used, irrespective of the relative magnitudes of the sources of these funds (current liabilities, debt and equity)
ROCE shows how much a company has earned on invested long-term funds (permanently employed capital = equity + LT debt)

20. Figure 9.1 Capital employed
Assets
Financing
Fixed assets
Equity
Net working capital
LT Debt
Current assets
Current liabilities
Capital employed
Capital employed

21. Earnings per share (EPS)
Shows how much of a period’s net profit has been earned by each ordinary share outstanding (basic EPS) or by shares outstanding plus all potential shares (diluted EPS)
Potential shares are equity instruments issued that can be converted into ordinary shares at the option of the holder of the instrument
IAS 33 Earnings per Share requires that listed companies disclose both basic and diluted EPS on the face of the income statement

22. Price/earnings ratio
EPS is used as input to a market ratio, the price/earnings or P/E ratio:
Price/Earnings =
Market price per share
EPS
Reflects how the market (market price) judges the company’s performance (growth expectations)
It is an inverted rate of return ratio
Also called the Earnings Multiple

23. Dividend yield ratio
The dividend yield ratio reflects the relationship between the dividends per share paid to shareholders and the current market price of a share:
Dividend Yield =
Dividend per share
Market price per share
Both P/E and dividend yield ratios of listed companies are published daily by major financial newspapers

24. Asset utilization ratios
Main ratios:
Total asset turnover
Fixed asset turnover
Inventory turnover
Receivable turnover
Turnover ratios measure efficiency of use of (categories of) assets
Tend to be industry-specific

25. Table 9.1 Asset utilization ratios

26. Financial strength ratios
Indicate the strength of a company’s financial position from the point of view of long-term solvency risk and short-term liquidity risk
Solvency refers to the long-term ability to generate cash internally or from external sources in order to meet long-term financial obligations
Liquidity refers to the ability to generate cash to meet short-term obligations

27. Long-term solvency risk ratios
Main ratios:
Debt/equity ratio
Gearing ratio
Interest and dividend cover
Gearing as indicator of default risk
Debt financing introduces financial risk because it implies fixed commitments in the form of interest payments and principal repayment and exposure to interest rate movements

28. Table 9.2 Long-term solvency risk ratios

29. Short-term liquidity risk ratios
Main ratios:
Current ratio and acid-test ratio
Credit given and credit obtained
Days inventory outstanding
Liquidity tests focus on the make-up of working capital and the activity level of its components
Low liquidity implies financial risk as inability to service short-term debt payments may lead to higher interest expense and, eventually, bankruptcy

30. Table 9.2 Short-term liquidity risk ratios

31. Analysing financial statements
Decode messages built into financial statements and use them to ‘tell the story’
Time series analysis of ratios
Combine patterns of financial ratios
Compare cross-sectionally
Ratio analysis is only part of an investment appraisal process - also consider:
Non-financial performance indicators
Broader economic variables
Information about future business plans, etc.

32. Worked example (1)

33. Worked example (2)

34. Worked example (3)

35. Worked example (4)

36. Worked example (5)

37. Worked example (6)

38. Worked example (7)