Chapter 3 Financial statement analysis (3).ppt
- 2. Financial and Management Accounting Chapter 3 Financial Statement Analysis Course leader : Million Gizaw (Assistant professor)
- 3. Lecture objectives 1. Understand the purpose of basic financial statements and their contents. 2. Understand what is meant by “convergence” in accounting standards. 3. Explain why financial statement analysis is important to the firm and to outside suppliers of capital. 4. Define, calculate, and categorize (according to liquidity, financial leverage, coverage, activity, and profitability) the major financial ratios and understand what they can tell us about the firm. 5. Define, calculate, and discuss a firm’s operating cycle and cash cycle. 6. Use ratios to analyze a firm's health and then recommend reasonable alternative courses of action to improve the health of the firm. 7. Analyze a firm’s return on investment (i.e., “earning power”) and return on equity using a DuPont approach. 8. Understand the limitations of financial ratio analysis. 9. Use trend analysis, common-size analysis, and index analysis to gain additional insights into a firm's performance.
- 4. • Trade Creditors – Focus on the liquidity of the firm. • Bondholders – Focus on the long-term cash flow of the firm. • Shareholders – Focus on the profitability and long-term health of the firm. Examples of External Uses of Statement Analysis
- 5. • Plan – Focus on assessing the current financial position and evaluating potential firm opportunities. • Control – Focus on return on investment for various assets and asset efficiency. • Understand – Focus on understanding how suppliers of funds analyze the firm. Examples of Internal Uses of Statement Analysis
- 6. • Convergence of Accounting Standards: Aims to narrow or remove differences so that investors can better understand financial statements prepared under different accounting frameworks • IASB – International Accounting Standards Board has the responsibility of IFRS • IFRS – International Financial Reporting Standards (EU countries adopted) • US GAAP – US Generally Accepted Accounting Principles determined by FASB • FASB – Financial Accounting Standards Board determines accounting standards for financial statements Global Accounting Standards
- 7. Income Statement • A summary of a firm’s revenues and expenses over a specified period, ending with net income or loss for the period. Balance Sheet • A summary of a firm’s financial position on a given date that shows total assets = total liabilities + owners’ equity. Primary Types of Financial Statements
- 8. a. How the firm stands on a specific date. b. What BW owned. c. Amounts owed by customers. d. Future expense items already paid. e. Cash/likely convertible to cash within 1 year. f. Original amount paid. g. Acc. deductions for wear and tear. Cash br. 90 Acct. Rec.c 394 Inventories 696 Prepaid Exp d 5 Accum Tax Prepay 10 Current Assetse $1,195 Fixed Assets (@Cost)f 1030 Less: Acc. Depr. g (329) Net Fix. Assets $ 701 Investment, LT 50 Other Assets, LT 223 Total Assetsb $2,169 BW Balance Sheet (thousands) Dec. 31, 2020a BWs’ Balance Sheet (Asset Side)
- 9. a. Note, Assets = Liabilities + Equity. b. What BW owed and ownership position. c. Owed to suppliers for goods and services. d. Unpaid wages, salaries, etc. e. Debts payable < 1 year. f. Debts payable > 1 year. g. Original investment. h. Earnings reinvested. Notes Payable $ 290 Acct. Payablec 94 Accrued Taxes d 16 Other Accrued Liab. d 100 Current Liab. e $ 500 Long-Term Debt f 530 Shareholders’ Equity Com. Stock ($1 par) g 200 Add Pd in Capital g 729 Retained Earnings h 210 Total Equity $1,139 Total Liab/Equitya,b $2,169 Basket Wonders Balance Sheet (thousands) Dec. 31, 2020 BWs’ Balance Sheet (Liability Side)
- 10. a. Measures profitability over a time period. b. Received, or receivable, from customers. c. Sales comm., adv., officers’ salaries, etc. d. Operating income. e. Cost of borrowed funds. f. Taxable income. g. Amount earned for shareholders. Net Sales $ 2,211 Cost of Goods Sold b 1,599 Gross Profit $ 612 SG&A Expenses c 402 EBITd $ 210 Interest Expensee 59 EBT f $ 151 Income Taxes 60 EATg $ 91 Cash Dividends 38 Increase in RE $ 53 Basket Wonders Statement of Earnings (in thousands) for Year Ending December 31, 2020a BW’ Income Statement
- 11. Types of Comparisons Internal Comparisons External Comparisons A Financial Ratio is an index that relates two accounting numbers and is obtained by dividing one number by the other. Use of Financial Ratios
- 12. This involves comparing the ratios of one firm with those of similar firms or with industry averages. Similarity is important as one should compare “apples to apples.” External Comparisons and Sources of Industry Ratios
- 13. Types of Ratios Ratio can be classified as Balance sheet ratios Income statement/Balance sheet ratios Additionally, we can further subdivide financial ratios into five distinct types: Liquidity ratio Financial leverage (or debt) ratio Coverage ratio Activity ratio and Profitability ratios.
- 14. Current Current Assets Current Liabilities For BW’S December 31, 2020 Shows a firm’s ability to cover its current liabilities with its current assets. Balance Sheet Ratios Liquidity Ratios $1,195 $500 = 2.39 Liquidity Ratios
- 15. BW Industry 2.39 2.15 2.26 2.09 1.91 2.01 Year 2020 2019 2018 Current Ratio Ratio is stronger than the industry average. Liquidity Ratio Comparisons
- 16. Acid-Test (Quick) Current Assets - Inv Current Liabilities For BW’S December 31, 2020 Shows a firm’s ability to meet current liabilities with its most liquid assets. Balance Sheet Ratios Liquidity Ratios $1,195 – $696 $500 = 1.00 Liquidity Ratios
- 17. BW Industry 1.00 1.25 1.04 1.23 1.11 1.25 Year 2020 2019 2018 Acid-Test Ratio Ratio is weaker than the industry average. Liquidity Ratio Comparisons
- 18. • Strong current ratio and weak acid-test ratio indicates a potential problem in the inventories account. • Note that this industry has a relatively high level of inventories. Ratio BW Industry Current 2.39 2.15 Acid-Test 1.00 1.25 Summary of the Liquidity Ratio Comparisons
- 19. Trend Analysis of Current Ratio 1.5 1.7 1.9 2.1 2.3 2.5 2018 2019 2020 Analysis Year Ratio Value BW Industry Current Ratio – Trend Analysis Comparison
- 20. Trend Analysis of Acid-Test Ratio 0.5 0.8 1.0 1.3 1.5 2018 2019 2020 Analysis Year Ratio Value BW Industry Acid-Test Ratio – Trend Analysis Comparison
- 21. • The current ratio for the industry has been rising slowly at the same time the acid-test ratio has been relatively stable. • This indicates that inventories are a significant problem for BW. • The current ratio for BW has been rising at the same time the acid-test ratio has been declining. Summary of the Liquidity Trend Analyses
- 22. Debt-to-Equity Total Debt Shareholders’ Equity For BW’S December 31, 2020 Shows the extent to which the firm is financed by debt. Balance Sheet Ratios Financial Leverage Ratios $1,030 $1,139 = 0.90 Financial Leverage Ratios
- 23. BW Industry 0.90 0.90 0.88 0.90 0.81 0.89 Year 2020 2019 2018 Debt-to-Equity Ratio BW has average debt utilization relative to the industry average. Financial Leverage Ratio Comparisons
- 24. Debt-to-Total-Assets Total Debt Total Assets For BW’S December 31, 2020 Shows the percentage of the firm’s assets that are supported by debt financing. Balance Sheet Ratios Financial Leverage Ratios $1,030 $2,169 = 0.47 Financial Leverage Ratios
- 25. BW Industry 0.47 0.47 0.47 0.47 0.45 0.47 Year 2020 2019 2018 Debt-to-Total-Asset Ratio BW has average debt utilization relative to the industry average. Financial Leverage Ratio Comparisons
- 26. Total Capitalization Total Debt Total Capitalization For BW’S December 31, 2020 Shows the relative importance of long-term debt to the long-term financing of the firm. Balance Sheet Ratios Financial Leverage Ratios $1,030 $1,669 = 0.62 (i.e., LT-Debt + Equity) Financial Leverage Ratios
- 27. BW Industry 0.62 0.60 0.62 0.61 0.67 0.62 Year 2020 2019 2018 Total Capitalization Ratio BW has average long-term debt utilization relative to the industry average. Financial Leverage Ratio Comparisons
- 28. Interest Coverage EBIT Interest Charges For BW’S December 31, 2020 Indicates a firm’s ability to cover interest charges. Income Statement Ratios Coverage Ratios $210 $59 = 3.56 Coverage Ratios
- 29. BW Industry 3.56 5.19 4.35 5.02 10.30 4.66 Year 2020 2019 2018 Interest Coverage Ratio BW has below average interest coverage relative to the industry average. Coverage Ratio Comparisons
- 30. Trend Analysis of Interest Coverage Ratio 3.0 5.0 7.0 9.0 11.0 2018 2019 2020 Analysis Year Ratio Value BW Industry Coverage Ratio – Trend Analysis Comparison
- 31. • This indicates that low earnings (EBIT) may be a potential problem for BW. • Note, we know that debt levels are in line with the industry averages. • The interest coverage ratio for BW has been falling since 2018. It has been below industry averages for the past two years. Summary of the Coverage Trend Analysis
- 32. Receivable Turnover Annual Net Credit Sales Receivables For BW’S December 31, 2020 Indicates quality of receivables and how successful the firm is in its collections. Income Statement/ Balance Sheet Ratios Activity Ratios $2,211 $394 = 5.61 (Assume all sales are credit sales.) Activity Ratios
- 33. Avg Collection Period Days in the Year Receivable Turnover For BW’S December 31, 2020 Average number of days that receivables are outstanding. (or RT in days) Income Statement/ Balance Sheet Ratios Activity Ratios 365 5.61 = 65 days Activity Ratios
- 34. BW Industry 65.0 65.7 71.1 66.3 83.6 69.2 Year 2020 2019 2018 Average Collection Period BW has improved the average collection period to that of the industry average. Activity Ratio Comparisons
- 35. Payable Turnover (PT) Annual Credit Purchases Accounts Payable For BW’S December 31, 2020 Indicates the promptness of payment to suppliers by the firm. Income Statement/ Balance Sheet Ratios Activity Ratios $1551 $94 = 16.5 (Assume annual credit purchases = $1,551.) Activity Ratios
- 36. PT in Days Days in the Year Payable Turnover For BW’S December 31, 2020 Average number of days that payables are outstanding. Income Statement/ Balance Sheet Ratios Activity Ratios 365 16.5 = 22.1 days Activity Ratios
- 37. BW Industry 22.1 46.7 25.4 51.1 43.5 48.5 Year 2020 2019 2018 Payable Turnover in Days BW has improved the PT in Days. Is this good? Activity Ratio Comparisons
- 38. Inventory Turnover Cost of Goods Sold Inventory For BW’S December 31, 2020 Indicates the effectiveness of the inventory management practices of the firm. Income Statement/ Balance Sheet Ratios Activity Ratios $1,599 $696 = 2.30 Activity Ratios
- 39. BW Industry 2.30 3.45 2.44 3.76 2.64 3.69 Year 2020 2019 2018 Inventory Turnover Ratio BW has a very poor inventory turnover ratio. Activity Ratio Comparisons
- 40. Trend Analysis of Inventory Turnover Ratio 2.0 2.5 3.0 3.5 4.0 2018 2019 2020 Analysis Year Ratio Value BW Industry Inventory Turnover Ratio – Trend Analysis Comparison
- 41. Total Asset Turnover Net Sales Total Assets For BWs December 31, 2020 Indicates the overall effectiveness of the firm in utilizing its assets to generate sales. Income Statement/ Balance Sheet Ratios Activity Ratios $2,211 $2,169 = 1.02 Activity Ratios
- 42. BW Industry 1.02 1.17 1.03 1.14 1.01 1.13 Year 2020 2019 2018 Total Asset Turnover Ratio BW has a weak total asset turnover ratio. Why is this ratio considered weak? Activity Ratio Comparisons
- 43. Gross Profit Margin Gross Profit Net Sales For BW’S December 31, 2020 Indicates the efficiency of operations and firm pricing policies. Income Statement/ Balance Sheet Ratios Profitability Ratios $612 $2,211 = 0.277 Profitability Ratios
- 44. BW Industry 27.7% 31.1% 28.7 30.8 31.3 27.6 Year 2020 2019 2018 Gross Profit Margin BW has a weak Gross Profit Margin. Profitability Ratio Comparisons
- 45. Trend Analysis of Gross Profit Margin 25.0 27.5 30.0 32.5 35.0 2018 2019 2020 Analysis Year Ratio Value (%) BW Industry Gross Profit Margin – Trend Analysis Comparison
- 46. Net Profit Margin Net Profit after Taxes Net Sales For BWs December 31, 2020 Indicates the firm’s profitability after taking account of all expenses and income taxes. Income Statement/ Balance Sheet Ratios Profitability Ratios $91 $2,211 = 0.041 Profitability Ratios
- 47. BW Industry 4.1% 8.2% 4.9 8.1 9.0 7.6 Year 2020 2019 2018 Net Profit Margin BW has a poor Net Profit Margin. Profitability Ratio Comparisons
- 48. Trend Analysis of Net Profit Margin 4 5 6 7 8 9 10 2018 2019 2020 Analysis Year Ratio Value (%) BW Industry Net Profit Margin – Trend Analysis Comparison
- 49. Return on Investment Net Profit after Taxes Total Assets For BW’S December 31, 2020 Indicates the profitability on the assets of the firm (after all expenses and taxes). Income Statement/ Balance Sheet Ratios Profitability Ratios $91 $2,160 = 0.042 Profitability Ratios
- 50. BW Industry 4.2% 9.6% 5.0 9.1 9.1 10.8 Year 2020 2019 2018 Return on Investment BW has a poor Return on Investment. Profitability Ratio Comparisons
- 51. Trend Analysis of Return on Investment 4 6 8 10 12 2018 2019 2020 Analysis Year Ratio Value (%) BW Industry Return on Investment – Trend Analysis Comparison
- 52. Return on Equity Net Profit after Taxes Shareholders’ Equity For BW’S December 31, 2020 Indicates the profitability to the shareholders of the firm (after all expenses and taxes). Income Statement/ Balance Sheet Ratios Profitability Ratios $91 $1,139 = 0.08 Profitability Ratios
- 53. BW Industry 8.0% 18.0% 9.4 17.2 16.6 20.4 Year 2020 2019 2018 Return on Equity BW has a poor Return on Equity. Profitability Ratio Comparisons
- 54. Trend Analysis of Return on Equity 7.0 10.5 14.0 17.5 21.0 2018 2019 2020 Analysis Year Ratio Value (%) BW Industry Return on Equity – Trend Analysis Comparison
- 55. ROI2020 = 0.041 × 1.02 = 0.042 or 4.2% ROIIndustry = 0.082 × 1.17 = 0.096 or 9.6% (Note: values are rounded) ROI = Net profit margin × Total asset turnover Earning Power = Sales profitability × Asset efficiency Return on Investment and the Du Pont Approach
- 56. ROE2020 = 0.041 × 1.02 × 1.90 = 0.080 ROEIndustry = 0.082 × 1.17 × 1.88 = 0.180 (Note: values are rounded) Return On Equity = Net profit margin X Total asset turnover X Equity Multiplier Equity Multiplier = Total Assets Shareholders’ Equity Return on Equity and the Du Pont Approach
- 57. • The profitability ratios for BW have ALL been falling since 2018. Each has been below the industry averages for the past three years. • This indicates that COGS and administrative costs may both be too high and a potential problem for BW. • Note, this result is consistent with the low interest coverage ratio. Summary of the Profitability Trend Analyses
- 58. 3- Computing Market Value Measures Market Price = $25 per share Shares outstanding = 200,000 PE Ratio = Price per share/Earnings per share 25 / 0.445 = 56.2 times Market-to-book ratio = market value per share/book value per share 56.2 / (2,169,000 / 200,000) = 5.2 times
- 59. • Inventories are too high. • May be paying off creditors (accounts payable) too soon. • COGS may be too high. • Selling, general, and administrative costs may be too high. Summary of Ratio Analyses
- 60. An analysis of percentage financial statements where all balance sheet items are divided by total assets and all income statement items are divided by net sales or revenues. Common-Size Analysis
- 61. BW’S’ Common Size Balance Sheets
- 62. Regular (thousands of $) Common-Size (%) Liab+Equity 2018 2019 2020 2018 2019 2020 Note Pay 290 295 290 23.71 14.43 13.37 Acct Pay 81 94 94 6.62 4.60 4.33 Accr Tax 13 16 16 1.06 0.78 0.74 Other Accr 15 100 100 1.23 4.89 4.61 Tot CL 399 505 500 32.62 24.71 23.05 LT Debt 150 453 530 12.26 22.16 24.44 Equity 674 1,086 1,139 55.11 53.13 52.51 Tot L+E 1,223 2,044 2,169 100.0 100.0 100.0 Basket Wonders’ Common- Size Balance Sheets
- 63. Regular (thousands of $) Common-Size (%) 2018 2019 2020 2018 2019 2020 Net Sales 1,235 2,106 2,211 100.0 100.0 100.0 COGS 849 1,501 1,599 68.7 71.3 72.3 Gross Profit 386 605 612 31.3 28.7 27.7 Adm. 180 383 402 14.6 18.2 18.2 EBIT 206 222 210 16.7 10.5 9.5 Int Exp 20 51 59 1.6 2.4 2.7 EBT 186 171 151 15.1 8.1 6.8 EAT 112 103 91 9.1 4.9 4.1 Cash Div 50 50 50 4.0 2.4 2.3 Basket Wonders’ Common- Size Income Statements
- 64. An analysis of percentage financial statements where all balance sheet or income statement figures for a base year equal 100.0 (percent) and subsequent financial statement items are expressed as percentages of their values in the base year. Index Analyses
- 65. Regular (thousands of $) Indexed (%) Assets 2018 2019 2020 2018 2019 2020 Cash 148 100 90 100.0 67.6 60.8 AR 283 410 394 100.0 144.9 139.2 Inv 322 616 696 100.0 191.3 216.1 Other CA 10 14 15 100.0 140.0 150.0 Tot CA 763 1,140 1,195 100.0 149.4 156.6 Net FA 349 631 701 100.0 180.8 200.9 LT Inv 0 50 50 100.0 inf. inf. Other LT 111 223 223 100.0 200.9 200.9 Tot Assets 1,223 2,044 2,169 100.0 167.1 177.4 Basket Wonders’ Indexed Balance Sheets
- 66. Regular (thousands of $) Indexed (%) Liab+Equity 2018 2019 2020 2018 2019 2020 Note Pay 290 295 290 100.0 101.7 100.0 Acct Pay 81 94 94 100.0 116.0 116.0 Accr Tax 13 16 16 100.0 123.1 123.1 Other Accr 15 100 100 100.0 666.7 666.7 Tot CL 399 505 500 100.0 126.6 125.3 LT Debt 150 453 530 100.0 302.0 353.3 Equity 674 1,086 1,139 100.0 161.1 169.0 Tot L+E 1,223 2,044 2,169 100.0 167.1 177.4 Basket Wonders’ Indexed Balance Sheets
- 67. Regular (thousands of $) Indexed (%) 2018 2019 2020 2018 2019 2020 Net Sales 1,235 2,106 2,211 100.0 170.5 179.0 COGS 849 1,501 1,599 100.0 176.8 188.3 Gross Profit 386 605 612 100.0 156.7 158.5 Adm. 180 383 402 100.0 212.8 223.3 EBIT 206 222 210 100.0 107.8 101.9 Int Exp 20 51 59 100.0 255.0 295.0 EBT 186 171 151 100.0 91.9 81.2 EAT 112 103 91 100.0 92.0 81.3 Cash Div 50 50 50 100.0 100.0 100.0 Basket Wonders’ Indexed Income Statements
- 68. THANK YOU End of lecture 3