2. Financial Statement and Ratio Analysis
process of evaluating relationships between
component parts of the firm’s financial statements
develop insights into the financial performance of
companies
provides a way to examine how a firm has
performed relative to its peers and relative to its own
historical performance.
3. Why a firm’s ratios are different from its
peers or its own historical performance?
product and market strategy used
effectiveness of management team at implementing its
strategy
financial strategy used
accounting methods used for reporting the same underlying
economic events
We should have a clear understanding of how a firm’s accounting decisions
compare with those of its competitors, or with its own decisions in prior years.
If there are important differences in accounting decisions, it may be necessary
to make adjustments to the affected firm’s financial statements to ensure that
ratio comparisons isolate differences in strategy or performance.
4. Classic Tools and Techniques Of Financial
Analysis
1. Horizontal Analysis
involves the computation of peso amount changes and
percentage changes from the previous to the current year
2. Vertical Analysis
involves the percentage changes to bring out the quantitative
relationships existing among different items to the total in a
single statement.
3. Ratio Analysis
an important means of stating the relationship between two
numbers
ratios reduce the data being compared to more meaningful
terms, and they bring out more clearly certain relationship that
may otherwise be overlooked.
5. Ratio Analysis:
DuPont Formula (F – I – O Method)
Perspective: SHAREHOLDERS
Goal of a firm: maximization of shareholders’
wealth
Starting point:
computation of RETURN ON EQUITY (ROE)
ROE = Net Income
Average Shareholders’ Equity
6. Return on Equity (ROE)
indicates how profitably the firm has been able
to invest shareholder funds for the period
Why firms generate high ROEs:
they are in a superior industry
they make more risky investments and so have to
provide investors with a higher return,
they are able to execute their strategy more
effectively than their competitors.
7. DuPont Formula (F – I – O Method)
helps us get a better understanding of reasons for differences in
ROEs across firms
recognizes the three fundamental factors driving ROE:
NET PROFIT MARGIN (reflecting how well the firm
manages its operations),
ASSET TURNOVER (reflecting how efficiently it
uses its assets)
FINANCIAL LEVERAGE (what kind of financing
strategy used)
ROE = Net Income = Net Income * Sales * Assets
Equity Sales Assets Equity
= Net Profit Margin * Asset Turnover * Financial Leverage
= Operating * Investing * Financing
8. OPERATING: Net Profit Margins
otherwise known as return on sales
reflect how well the firm manages its operations
show the profitability of each dollar of sales.
depend on a firm’s strategy and its industry.
industries that rely heavily on volume (e.g. supermarkets), tend
to have low margins,
industries that sell low volumes of specialty products ( e.g.
jewelry stores) tend to have high margins.
firms with the strategy to be the low cost provider in their
industry have lower sales margins than firms with differentiated
strategies.
Net Profit Margin = Net Income
Sales
9. INVESTMENT EFFICIENCY:
Asset Turnover
reflects how efficiently it uses its assets
measures the multiple of sales generated per dollar of assets
heavily affected by a company’s investment strategy and the
technology used to deliver its products or service.
capital intensive industries that take advantage of economies of
scale (e.g. utilities) tend to have low turnover ratios, whereas
labor-intensive service industries tend to have high turnover.
Asset Turnover = Sales
Average Total Assets
10. INVESTMENT EFFICIENCY:
Asset Turnover
Also affected by working capital management
Working capital = receivables + inventory - payables.
Firms that are able to collect promptly from their customers,
to hold relatively little inventory, or to get suppliers to finance
inventory are able to use less of their own funds or working
capital, increasing turnover.
Several measures of working capital management include:
Days receivable = 365 * (average receivables/sales)
Days inventory = 365 * (average inventory/ cost of sales)
Days payable = 365 * (average payable / cost of sales )
Receivable turnover = sales / average receivables
Inventory turnover = cost of sales / average inventory
Payable Turnover = cost of sales / average payables
11. FINANCING STRATEGY:
Financial Leverage
measures the multiple of assets to equity, therefore, the higher the leverage
multiple the higher the potential risk and reward.
enables a firm to substantially increase its asset base relative to its equity base,
thus allowing it to increase ROE.
A firm is successful at using leverage (positive leverage) if it earns a higher rate of
return on borrowed funds than the after-tax interest rate costs for borrowing the
money.
However, leverage also creates risk for shareholders.
Unlike equity financing where dividend declaration is at the discretion of the board, debt
financing has predefined interest payment terms and schedules must be met.
A firm faces risk of financial distress if its fails to meet these commitments.
Financial Leverage = Average Total Assets
Average Shareholders’ Equity
12. FINANCING STRATEGY:
Financial Leverage
The firm’s ability to meet its financial commitments
which requires calculation of short-term liquidity and
long term solvency ratios should also be analyzed
Short-term liquidity Ratios
try to explain whether the firm has the financial means to
pay on its current obligations defined as obligations
coming due within the year.
Long-term solvency Ratios
ability to meet interest payments, preferred
dividends, and other fixed charges.
13. FINANCING STRATEGY:
Financial Leverage
Short-term Liquidity Ratios
CURRENT RATIO
Most common short-term liquidity ratio
Current ratio = current assets
current liabilities
compares all the current resources of the firm, cash, marketable
securities, accounts receivable, prepaid expenses, and inventory,
to all the current obligations of the firm.
QUICK RATIO
includes only the current assets that can be used immediately to
extinguish any current liabilities.
Quick ratio = (cash + marketable securities + A/R)
current liabilities
14. FINANCING STRATEGY:
Financial Leverage
Long-term solvency Ratios
NET DEBT TO EQUITY RATIO
Net Interest Bearing Debt to Equity = (interest bearing debt – cash)
Shareholders’ equity
measures the degree to which a firm’s activities are supported by debt relative to
owner’s equity.
Cash is typically considered as negative debt and therefore deducted from the
numerator in the ratio.
INTEREST COVERAGE RATIO (Times Interest Earned)
Interest Coverage Ratio = Profits before interest and taxes
Total Interest Charges
This ratio assesses the current ability of a firm to meet its interest payments.
It is a multiple that measures how many times interest charges the corporation has
earned on a pretax basis.
Alternative method for calculating this ratio: cash flow coverage ratio
uses a numerator of cash flows rather than earnings before taxes.
The larger the coverage ratio, the greater the cushion the firm has to meet interest
obligations.
15. Summary
financial ratios provide a useful way of enabling users of financial
statements to compare the performance of one firm with its
peers, or with its own historical performance
Many different ratios are popular in practice.
Successful ratio analysis requires a thorough understanding of
accounting differences between the firms compared, as well as a
deep understanding of their business differences.
It is important to dig deeply to understand the causes for any
ratio differences generated through your analysis.