Chapter 2.1 - Financial-Statement-Analysis.ppt
- 2. CHAPTER 2 CHAPTER 2 Review of Financial Review of Financial Statement Preparation, Statement Preparation, Analysis, and Analysis, and Interpretation Interpretation
- 4. • To know how to compute different financial ratios such as liquidity, leverage, efficiency or turnover, and profitability ratios Learning Objective
- 5. Uses of Financial Statement Analysis It is used for investment and credit decisions. What are the USES of What are the USES of FINANCIAL FINANCIAL STATEMENT ANALYSIS STATEMENT ANALYSIS? ? It is also used for regulating companies. It used by management for monitoring performance. It is used in identifying strategies to further improve the company’s operations.
- 6. Financial Ratios 1. Profitability ratios 2. Liquidity ratios 3. Leverage ratios 4. Efficiency ratios For this chapter, the FINANCIAL For this chapter, the FINANCIAL RATIOS given below will be discussed. RATIOS given below will be discussed.
- 7. Different Profitability Ratios 1. Return on Equity (ROE) 2. Return on Assets (ROA) 3. Gross Profit Margin 4. Operating Profit Margin 5. Net Profit Margin What RATIOS are used to measure the What RATIOS are used to measure the PROFITABILITY of a company? PROFITABILITY of a company?
- 8. Profitability Ratio: Return on Equity (ROE) ROE measures the amount of net income earned in relation to stockholders’ equity. The formula for computing ROE is:
- 9. Profitability Ratio: Return on Assets (ROA) ROA measures the ability of a company to generate income out of its resources. The formula for computing ROA is:
- 10. Profitability Ratio: Gross Profit Margin Gross Profit Margin is a profitability ratio that measures the ability of a company to cover its cost of goods sold from its sales. The formula for Gross Profit Margin is:
- 11. Profitability Ratio: Operating Profit Margin Operating Profit Margin measures the amount of income generated from the core business of a company. The formula for Operating Profit Margin is: Operating Profit Margin is computed as the difference between revenues and the sum of cost of revenues or sales and operating expenses.
- 12. Profitability Ratio: Net Profit Margin Net Profit Margin measures how much net profit a company generates for every peso of sales or revenues that it generates. The formula for Net Profit Margin is: Net income is the amount left after all expenses including income taxes are deducted from sales or revenues.
- 13. Different Liquidity Ratios 1. Current Ratio 2. Acid-Test Ratio What are the two commonly used What are the two commonly used LIQUIDITY RATIOS? LIQUIDITY RATIOS?
- 14. Liquidity Ratio: Current Ratio The formula for computing Current Ratio is: Current assets include cash and other assets which are expected to be converted to cash within 12 months such as accounts receivable and inventories. Current assets also include prepayments such as prepaid rent and prepaid insurance. Current liabilities include obligations that are expected to be settled or paid within 12 months such as accounts payable, accrued expenses payable such as accrued salaries, and current portion of long-term debt.
- 15. Liquidity Ratio: Acid-Test Ratio The formula for computing Quick Asset Ratio is: Acid-Test Ratio is sometimes referred to as Quick Asset Ratio. The quick asset ratio is a stricter measure of a company’s liquidity position. OR
- 16. Different Leverage Ratios 1. Debt Ratio 2. Debt to Equity Ratio 3. Interest Coverage Ratio What LEVERAGE RATIOS will be What LEVERAGE RATIOS will be discussed in this chapter? discussed in this chapter?
- 17. Leverage Ratio: Debt Ratio The formula for computing Debt Ratio is: Debt Ratio measures how much of the total assets are financed by liabilities.
- 18. Leverage Ratio: Debt to Equity Ratio The formula for computing Debt to Equity Ratio is: Debt to Equity Ratio is a variation of the Debt Ratio. A Debt to Equity Ratio of more than one means that a company has more liabilities as compared to stockholders’ equity.
- 19. Leverage Ratio: Interest Coverage Ratio The formula for computing Interest Coverage Ratio is: Interest Coverage Ratio provides information if a company has enough operating income to cover interest expense. EBIT stands for earnings before interest and taxes.
- 20. 1. Total Asset Turnover Ratio 2. Fixed Asset Turnover Ratio 3. Accounts Receivable Turnover Ratio 4. Inventory Turnover Ratio 5. Accounts Payable Turnover Ratio Different Efficiency Ratios What EFFICIENCY RATIOS will be What EFFICIENCY RATIOS will be discussed in this chapter? discussed in this chapter? From these three ratios, operating cycle and cash conversion cycle can be computed.
- 21. Efficiency Ratio: Total Asset Turnover Ratio The formula for computing Total Asset Turnover Ratio is: Total Asset Turnover Ratio measures the company’s ability to generate revenues for every peso of asset invested. Total Asset Turnover Ratio is an indicator of how productive the company is in utilizing its resources.
- 22. Efficiency Ratio: Fixed Asset Turnover Ratio The formula for computing Fixed Asset Turnover Ratio is: If a company is heavily invested in property, plant, and equipment (PPE) or fixed assets, it pays to know how efficient the management of these assets must be.
- 23. Efficiency Ratio: Accounts Receivable Turnover Ratio Accounts Receivable Turnover Ratio measures the efficiency by which accounts receivable are managed. A high Accounts Receivable Turnover Ratio means efficient management of receivables. The formula for computing Accounts Receivable Turnover Ratio is:
- 24. Efficiency Ratio: Inventory Turnover Ratio Inventory Turnover Ratio measures the company’s efficiency in managing its inventories. Trading and manufacturing companies and companies that are dealing with highly perishable products and those that are prone to technological obsolescence must pay close attention to this ratio to minimize losses. The formula for computing Inventory Turnover Ratio is:
- 25. Efficiency Ratio: Accounts Payable Turnover Ratio Accounts Payable Turnover Ratio provides information regarding the rate by which trade payables are paid. The formula for computing Accounts Payable Turnover Ratio is:
- 26. The Operating Cycle By adding the average collection period and days’ inventories, the operating cycle can be computed. The formula for computing Operating Cycle is: How can the OPERATING How can the OPERATING CYCLE be computed? CYCLE be computed? This operating cycle covers the period from the time the merchandise is bought to the time the proceeds from the sale are collected.
- 27. The Cash Conversion Cycle To find out how long it takes the company to collect receivables from the time the cost of the merchandise sold was actually paid, a Cash Conversion Cycle or sometimes called Net Trade Cycle can be computed. The formula for computing Cash Conversion Cycle is: How can the CASH CONVERSION How can the CASH CONVERSION CYCLE be computed? CYCLE be computed?
- 28. Self-Test Questions 1. What are the four major groups of financial ratios covered in this chapter? Explain each briefly. 2. Is it possible for a company to miss payment of its maturing obligations in spite of having high current ratio and quick asset ratio? Explain.
Editor's Notes
- #5: Before starting the discussion, tell the class that financial statement analysis can be used by managers, equity investors, creditors, regulators, labor unions, employees, the public, and potential investors and creditors.
- #8: Note to the class that in computing ROE, different approaches are observed. There are analysts who use the average of the stockholders’ equity for two accounting periods while others simply use the year-end balances. Whichever formula is used, consistency must be applied.
- #9: As an additional information on ROA, you may say: This ratio can be useful in making investment decisions. For example, if a company has an opportunity to expand and is not sure how to finance the expansion, the ROA can be used in making a decision. If the borrowing rate is greater than ROA, then it does not make sense to borrow for expansion. However, if the expected ROA with the expansion is greater than the borrowing rate, then management may consider borrowing to finance expansion. It is important to note to the students, however, that comparison of borrowing cost and ROA is only one of several factors to consider in expansion.
- #13: Tell the class that liquidity ratios measure the ability of a company to pay maturing obligations from its current assets.
- #14: Tell the class that current portion of long-term debt is the principal amount of a long-term loan expected to be paid within the next 12 months from the balance sheet date.
- #15: Note to the students that the first formula is a stricter measure of quick asset ratio.
- #16: Tell the class that leverage ratios show the capital structure of a company, that is, how much of the total assets of a company is financed by debt and how much is financed by stockholders’ equity. Leverage ratios can also be used to measure the company’s ability to meet long-term obligations.
- #20: Tell the class that efficiency ratios, otherwise known as turnover ratios, are called as such because they measure the management’s efficiency in utilizing the assets of the company. Note to the class that from the last three, operating cycle and cash conversion cycle (click mouse/pad to cue highlight) can be computed.
- #21: Tell the class to take note that in computing for Total Asset Turnover Ratio, ending balances for total assets or the average of total assets for the accounting period can be used. Whichever formula is used, note to the students that consistency must always be applied.
- #23: Explain to the students that if there are different types of receivables, consider only the trade account receivables, which are the accounts receivable created in the ordinary course of business. Also, if there are allowances for doubtful accounts, use the trade accounts receivables’ gross amount, which is an amount generally found in the notes to financial statements where more information about accounts receivable is disclosed. Also note that some analysts use average accounts receivable, instead of the ending accounts receivable. Whichever approach is used, note to them that consistency must always be applied.
- #24: Tell the class to take note that just like the computation of Accounts Receivable Turnover Ratio, either ending balance of the inventories or the average inventories for the accounting period can be used. Whichever number is used, note to them that consistency must always be observed. As an additional note, tell the class that manufacturing companies that may have three types of inventories—finished goods, work in process, and raw materials inventories—all must be included in the computation. This is to measure the company’s level of efficiency in managing this account.
- #27: Note to the class that the Cash Conversion Cycle is inversely related to the operating cash flows. This means that if the Cash Conversion Cycle is low, more operating cash flows can be expected and the reverse is true.
- #28: Ask the class to answer the questions on the slide.