ratio analysis comprehensive

Financial Statement Analysis for Decision Making

Opening Vignette - LAHORE LIMITEDA leading company in the health-care and consumer products industrySales revenues of Rs14-billionAssets of Rs13-billion

Opening Vignette - LAHORE LIMITEDHow would you compare LAHORE LIMITEDs performance against other industry competitors?Companies differ in size, so you cant compare absolute RUPEE amountsNeed to use ratios - tools to translate financial data into percentages - which can be compared across companies

Opening Vignette - LAHORE LIMITEDKARACHI LIMITEDSales revenues Rs33.4Net income 2.6Assets 28.0

Opening Vignette - LAHORE LIMITEDLAHORE LIMITEDSales revenues Rs13.7Net income 1.8Assets 13.0KARACHI LIMITEDSales revenues Rs33.4Net income 2.6Assets 28.0

Opening Vignette - LAHORE LIMITEDLAHORE LIMITEDSales revenues Rs13.7Net income 1.8Assets 13.0KARACHI LIMITEDSales revenues Rs33.4Net income 2.6Assets 28.0

Which company was better in generating net income from sales revenues earned?

Opening Vignette - LAHORE LIMITEDLAHORE LIMITEDSales revenues Rs13.7Net income 1.8Assets 13.0

You can use the return on sales ratio to compare KARACHI LIMITEDSales revenues Rs33.4Net income 2.6Assets 28.0

Which company was better in generating net income from sales revenues earned?

Opening Vignette - LAHORE LIMITEDKARACHI LIMITEDSales revenues Rs33.4Net income 2.6

Opening Vignette - LAHORE LIMITEDKARACHI LIMITEDSales revenues Rs33.4Net income 2.6

Rs2.6Rs33.4

= 7.78%

Opening Vignette - LAHORE LIMITEDLAHORE LIMITEDSales revenues Rs13.7Net income 1.8KARACHI LIMITEDSales revenues Rs33.4Net income 2.6

Rs2.6Rs33.4

= 7.78%

Opening Vignette - LAHORE LIMITEDLAHORE LIMITEDSales revenues Rs13.7Net income 1.8

Rs1.8Rs13.7

= 13.13%KARACHI LIMITEDSales revenues Rs33.4Net income 2.6

Rs2.6Rs33.4

= 7.78%

Opening Vignette - LAHORE LIMITEDLAHORE LIMITEDSales revenues Rs13.7KARACHI LIMITEDSales revenues Rs33.4

Although KARACHI LIMIDEDS sales were higher

Opening Vignette - LAHORE LIMITEDLAHORE LIMITEDSales revenues Rs13.7Net income 1.8

Rs1.8Rs13.7

= 13.13%KARACHI LIMITEDSales revenues Rs33.4Net income 2.6

Rs2.6Rs33.4

= 7.78%Bristol-Myers return on sales was nearly twice that of P&G

Chapter Learning Objectives1.Perform a horizontal analysis of comparative financial statements2.Perform a vertical analysis of financial statements3.Prepare common-size financial statements for benchmarking against the industry average and key competitors

Chapter Learning Objectives4.Use the statement of cash flows in decision making5.Compute the standard financial ratios used for decision making6.Use ratios in decision making7.Measure economic value added by a companys operations

Financial Statement AnalysisExternal users rely on publicly-available information to perform financial analysisSuch information is contained in corporate annual report

Annual Report ContentsFOUR BASIC FINANCIAL STATEMENTS

Annual Report ContentsFOUR BASIC FINANCIAL STATEMENTSFOOTNOTES TO THE FINANCIAL STATEMENTS


SUMMARY OF ACCOUNTING METHODS


SUMMARY OF ACCOUNTING METHODSMANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL STATEMENTS


SUMMARY OF ACCOUNTING METHODSMANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL STATEMENTSAUDITORS REPORT


SUMMARY OF ACCOUNTING METHODSMANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL STATEMENTSAUDITORS REPORTCOMPARATIVE FINANCIAL DATA FOR A SERIES OF YEARS

Financial Statement AnalysisBefore you jump to a decision, consider the following:1.Financial statements provide data about what happened during the accounting periodPick the one annual report component which provides investors and creditors with the most descriptive information about the corporations activities and financial condition

Financial Statement Analysis2.Investors and creditors use information contained in the annual report to:Forecast future income and cash flowsAssess risk of investing in or lending to the corporation

Financial Statement Analysis

MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL STATEMENTS4

Financial Statement AnalysisManagements discussion and analysis (MD&A) includes:Evaluation of current business operationsAssessment of future operations

Tools to Evaluate Financial Information

Tools to Evaluate Financial InformationHorizontal Analysis


Vertical Analysis


Vertical Analysis

Ratio Analysis

Chapter Objective 1Perform a horizontal analysis of comparative financial statements

Tools to Evaluate Financial Information

Horizontal AnalysisExamines percentage change in each item on the financial statementsCompares current years RUPEE amount with prior years RUPEE amountExpresses the change inRUPEESPercentage

Horizontal AnalysisFirst, calculate RUPEE change from base year (prior year) to current year

Horizontal AnalysisFirst, calculate RUPEE change from base year (prior year) to current year

Second, divide RUPEE change by base-year RUPEE amount

Horizontal AnalysisRUPEE AMOUNT INCREASE (DECREASE)Amounts in thousands


1996 1995 RUPEES %Receivables (net) Rs325,384 Rs272,225


1996 1995 RUPEES %Receivables (net) Rs325,384 Rs272,225

Difference


1996 1995 RUPEES %Receivables (net) Rs325,384 Rs272,225 Rs53,159

Difference


1996 1995 RUPEES %Receivables (net) Rs325,384 Rs272,225 Rs53,159

Divide


1996 1995 RUPEES %Receivables (net) Rs325,384 Rs272,225 Rs53,159 19.5%

Divide


1996 1995 RUPEES %Receivables (net) Rs325,384 Rs272,225 Rs53,159 19.5%Leasehold Improv. 314,933 273,015


1996 1995 RUPEES %Receivables (net) Rs325,384 Rs272,225 Rs53,159 19.5%Leasehold Improv. 314,933 273,015 41,918


1996 1995 RUPEES %Receivables (net) Rs325,384 Rs272,225 Rs53,159 19.5%Leasehold Improv. 314,933 273,015 41,918 15.3


1996 1995 RUPEES %Receivables (net) Rs325,384 Rs272,225 Rs53,159 19.5%Leasehold Improv. 314,933 273,015 41,918 15.3Notes Receivable 54,715 32,528


1996 1995 RUPEES %Receivables (net) Rs325,384 Rs272,225 Rs53,159 19.5%Leasehold Improv. 314,933 273,015 41,918 15.3Notes Receivable 54,715 32,528 22,187


1996 1995 RUPEES %Receivables (net) Rs325,384 Rs272,225 Rs53,159 19.5%Leasehold Improv. 314,933 273,015 41,918 15.3Notes Receivable 54,715 32,528 22,187 68.2


1996 1995 RUPEES %Receivables (net) Rs325,384 Rs272,225 Rs53,159 19.5%Leasehold Improv. 314,933 273,015 41,918 15.3Notes Receivable 54,715 32,528 22,187 68.2Total Assets 7,354,033 5,778,041


1996 1995 RUPEES %Receivables (net) Rs325,384 Rs272,225 Rs53,159 19.5%Leasehold Improv. 314,933 273,015 41,918 15.3Notes Receivable 54,715 32,528 22,187 68.2Total Assets 7,354,033 5,778,041 1,575,992


1996 1995 RUPEES %Receivables (net) Rs325,384 Rs272,225 Rs53,159 19.5%Leasehold Improv. 314,933 273,015 41,918 15.3Notes Receivable 54,715 32,528 22,187 68.2Total Assets 7,354,033 5,778,041 1,575,992 27.3

Trend PercentagesSpecialized form of horizontal analysisShows trend of financial statement items over longer time periods such as 5 or 10 years

Trend PercentagesBase year (earliest year in the time series) set at 100%All other years expressed as percentage of base year

Trend PercentagesIncome statement amounts for Rays Seafood Shack are presented in the next slideCompute the trend percentages for these items

Trend Percentages(AMOUNTS IN THOUSANDS )

1998 1997 1996 1995 1994 1993Net Sales Rs714 Rs553 Rs502 Rs474 Rs451 Rs346


1998 1997 1996 1995 1994 1993Net Sales Rs714 Rs553 Rs502 Rs474 Rs451 Rs346

Divide x 100

Net Sales 206% 160% 145% 137% 130% 100%


1998 1997 1996 1995 1994 1993Net Sales Rs714 Rs553 Rs502 Rs474 Rs451 Rs346Cost of Sales 373 265 201 259 280 193

Net Sales 206% 160% 145% 137% 130% 100%Cost of Sales 193 137 104 134 145 100


1998 1997 1996 1995 1994 1993Net Sales Rs714 Rs553 Rs502 Rs474 Rs451 Rs346Cost of Sales 373 265 201 259 280 193Gross Profit 341 288 301 215 171 153

Net Sales 206% 160% 145% 137% 130% 100%Cost of Sales 193 137 104 134 145 100Gross Profit 223 188 197 140 112 100

Horizontal Analysis and Trend Percentages: A SummaryTools used to compare financial results of companies of different sizes and/or in different industries

Vertical Analysis

Vertical Analysis

Vertical Analysis

Vertical AnalysisCompares each item on the financial statement to a key, or base, itemBase-item RUPEE amount always set to 100%Income statement Net sales = 100%Balance sheet Total assets = 100%

Vertical Analysis19X7 19X6 AMOUNT % AMOUNT %Net sales Rs430,013 100% Rs362,386 100%Cost of Goods Sold 336,589 78 284,897 79Gross Profit 93,424 22 77,489 21Selling, General & Admin. 72,363 17 65,096 18Income from Operations 21,061 5 12,393 3Income Taxes 7,072 2 4,350 2Net Income Rs13,989 3% Rs8,043 2%

Vertical AnalysisOnce financial statement items are converted into percentages of the base item, users can compare one companys financials against anothersThese are called common-size statements

Common-Size StatementsShow all items as percentages of the key, or base, amountUse no RUPEE amountsFacilitate financial statement comparison among different sized companiesImprove users ability to assess company performance against industry averages

Common-Size StatementsCan also be used to evaluate company performance over timeRefer to textbook Exhibit 13-6

Benchmarking Against the Industry AverageBenchmarking is a term used to describe the process of comparing a companys activities to a standard of excellence achieved by industry leaders

Benchmarking Against Key CompetitorsA company also can compare its common-size financials to those of its industrys leadersDetermine where it differsDesign and implement business processes to bring financial results in line with these benchmark entities

Statement of Cash Flows in Decision MakingSummarizes sources and uses of entitys cash flowsInternal and external decision makers want to see majority of cash inflows coming from operating activitiesWHY?

Statement of Cash Flows in Decision MakingCompany cannot stay in business for long if it cannot generate enough cash from operations to cover operating expensesWhile borrowing and investing activities provide cash for business use, long-term reliance on these activities for sources of cash is not advised

Using Ratios to Make Business Decisions

Using Ratios to Make Business Decisions

Ratio Analysis

Using Ratios to Make Business DecisionsRatios - the relationship between two items on financial statements - permit users to calculate a variety of financial comparisonsThese ratios can be compared to:Prior years financial resultsIndustry averagesBenchmark entities ratios

Using Ratios to Make Business DecisionsRatios measure an entitys ability to: Pay current liabilitiesSell inventory and collect receivablesPay long-term debtGenerate profits from operationsSustain shareholder wealth

Using Ratios to Make Business DecisionsAccess to computerized spreadsheets, integrated financial analysis software, and financial databases makes ratio calculation a snap!

Measuring the Companys Ability to Pay Current LiabilitiesOne measure of entitys ability to pay its current obligations is to look at working capital Current assets - current liabilities

2 ratios help users assess working capital information


2 ratios help users assess working capital informationCurrent ratio


2 ratios help users assess working capital informationCurrent ratioQuick (acid-test) ratio

Using Ratios to Make Business DecisionsWell use the Lands End, Inc., financial statements from textbook Chapter 1 to illustrate a variety of financial ratios for business decision makingAll RUPEE amounts presented are in thousands

Ability to Pay Current LiabilitiesCurrent ratio

Ability to Pay Current LiabilitiesCurrent ratio Current assetsCurrent liabilities

Ability to Pay Current LiabilitiesCurrent ratio Current assetsCurrent liabilities

Rs222,089Rs114,744

= 1.94

Ability to Pay Current LiabilitiesQuick ratio

Ability to Pay Current LiabilitiesQuick ratio Current assets - inventory - prepaid itemsCurrent liabilities

Ability to Pay Current LiabilitiesCurrent ratio Current assets - inventory - prepaid itemsCurrent liabilities

Rs25,240Rs114,744

= .22

Measuring the Companys Ability to Sell Inventory and Collect ReceivablesEntitys operating cycleTime to go from cash to inventory to receivables to cash is critical to generating cash inflows from operating activities3 ratios help users assess managements skill in selling inventory and collecting receivables

Measuring the Companys Ability to Sell Inventory and Collect ReceivablesInventory turnover1

Measuring the Companys Ability to Sell Inventory and Collect ReceivablesInventory turnover

A/R turnover12

Measuring the Companys Ability to Sell Inventory and Collect ReceivablesInventory turnover

A/R turnover

Days sales in receivables123

Inventory TurnoverNumber of times the average level of inventory is sold during the accounting year Measures time required to earn return on companys investment in inventory

Inventory TurnoverCost of goods soldAverage inventory

Inventory TurnoverCost of goods soldAverage inventory

Rs588,017(Rs164,816 + Rs168,652) / 2

= 3.53

Inventory TurnoverHigh ratio indicates ability to quickly sell inventoryToo high a ratio may indicate inadequate inventory levelsTurnover ratio should be compared to historical and industry averagesAnalyze significant variances

Accounts Receivable TurnoverNumber of times the average level of A/R is collected during the accounting year Measures ability to collect cash from credit customersRs

Accounts Receivable TurnoverNet credit salesAverage net A/R

Accounts Receivable TurnoverNet credit sales*Average net A/R

Rs1,031,548*(Rs8,064 + Rs4,459) / 2

= 165* Lands Ends ratio is not accurate. Net credit sales figure is unavailable. Net sales from the income statement used instead.

Days Sales in ReceivablesNumber of equivalent days sales revenue represented by the outstanding A/R balance Measures A/R balance in terms of number of days it would take to generate the equivalent RUPEE amount of salesRs

Days Sales in ReceivablesAverage net A/R(Net sales / 365 days)

Days Sales in ReceivablesAverage net A/R(Net sales / 365 days)

Rs6,262(Rs1,031,548 / 365 days)

= 2.22 days

Days Sales in ReceivablesLands Ends receivables ratios look unusual when compared to the textbook and industry averagesThis is due to significant volume of sales made with bank cards like VISA, MasterCard, and American Express

Days Sales in ReceivablesThese sales treated like cash sales - merchandisers receive payment for them almost immediatelyLands Ends receivables are rather small when compared to total net sales

Measuring the Companys Ability to Pay Long-Term DebtBondholders and long-term lenders are concerned about an entitys ability to repay debt principal and accumulated interest on long-term notes and loans2 ratios help these users assess the entitys ability to pay its long-term obligationsDebt ratioTimes-interest-earned ratio

Debt RatioRelationship between companys total liabilities and total assetsMeasures proportion of total assets provided through debt1 - debt ratio = proportion of assets provided by equity

Debt RatioTotal LiabilitiesTotal Assets

Debt RatioTotal LiabilitiesTotal Assets

Rs122,305Rs323,497

= .38

Debt RatioIf debt ratio = 1.0, company used all debt to finance acquisition of its assetsA highly unlikely situationThus, debt ratio is generally less than 1.0LOANS,NOTES,BONDS,ETC.

Debt RatioThe higher the ratio, the more cash the company must commit toward paying annual interest expense and loan principal As a result, companys cash flow might be negatively affected

Debt RatioLenders and creditors might require company to appropriate portion of retained earnings to ensure sufficient assets to repay interest and loan principal

Times-Interest-Earned RatioRelationship between companys net income from operations and interest expenseMeasures ability of company to cover, or pay for, its interest expense out of operating income

Times-Interest-Earned RatioIncome from operationsInterest expense

Times-Interest-Earned RatioIncome from operationsInterest expense

Rs49,165Rs2,771

= 17.7

Times-Interest-Earned RatioLands Ends high ratio indicates ease in meeting debt interest payments

Times-Interest-Earned RatioA low ratio would signal possible difficulties in making payments to lenders and bondholders

Measuring a Companys ProfitabilityFinancial analysts pay close attention to ratios which assess a companys ability to generate profits and operate efficientlyCreditors and investors rely on forecasts of a companys potential to generate net income when they make lending and investing choices

Measuring a Companys Profitability4 profitability ratios are commonly used in financial statement analysis


Return on sales


Return on sales Return on assets


Return on sales Return on assetsReturn on equity


Return on sales Return on assetsReturn on equityEarnings per share

Return on SalesRelationship between a companys net income and net salesMeasures managements ability to efficiently and effectively manage company operationsShows percentage of each net sales RUPEE earned as net income

Return on SalesNet incomeNet sales revenue

Return on SalesNet incomeNet sales revenue

Rs 30,555Rs1,031,548

= .0296

Return on SalesHigher rate tells users that more net sales RUPEES add to a companys profitsAnd fewer RUPEES go to cover company expensesCompany conducts its business effectively, manages expenses Net Income

Return on AssetsRatio of the return to the two groups that provide financing to the companyCreditors and investors and average assets owned during the period Measures companys success in generating income from its available resources

Return on AssetsNet income + interest expenseAverage total assets

Return on AssetsNet income + interest expenseAverage total assets

Rs30,555 + 2,771(Rs323,497 + Rs297,613) / 2

= .1073

Return on Assets Why do we add back interest expense to net income?

Return on AssetsTotal assets are financed by 2 sources:Investors (equity)Creditors (debt)Net income is the return attributable to investors in the companys stockInterest expense is the return paid to creditors for using their funds to acquire assets

Return on EquityRelationship between net income available to common stockholders and the equity they provideMeasures companys success in using stockholders investments to generate net income

Return on EquityNet income - preferred dividendsCommon contributed capital + retained earnings

Return on EquityNet income - preferred dividendsCommon contributed capital + retained earnings

Rs30,555*(Rs286,676 + Rs255,773) / 2

= .1126

* Lands End does not have preferred stock

Earnings Per ShareRelationship between net income available to common stockholders and the number of shares of common stock issuedExpresses net income in terms of one share of the companys common stock

Earnings Per ShareNet income - preferred dividends# of shares of common stock outstanding

Earnings Per ShareNet income - preferred dividends# of shares of common stock outstanding

Rs30,555,000*40,221,000 shares

= Rs.76

* Lands End does not have preferred stock; numbers shown are actual amounts

Earnings Per ShareIn addition to net income, EPS is presented for several other elements on the corporate income statement Discontinued operationsExtraordinary itemsCumulative effect of accounting changeEarnings per share (EPS) disclosure on the face of the corporate income statement is mandatory

Analyzing the Companys Stock as an Investment

Analyzing the Companys Stock as an InvestmentInvestors expect to receive 2 types of returns on their investments in a corporations common stockGains earned when they sell the corporations stockPeriodic dividends paid by the corporation to its stockholders

Analyzing the Companys Stock as an InvestmentFinancial analysts use several ratios to assess value of stock investmentsPrice/earnings ratioDividend yieldBook value

Price/Earnings RatioRelationship between a stocks market price and its earnings per shareMeasures the number of times one share of stock sells above the current periods reported earnings Assists financial analysts in deciding if a stock is overpriced or underpriced

Price/Earnings RatioCalculating the P/E ratio

Price/Earnings RatioCalculating the P/E ratio

Market value of stockEarnings per share

Price/Earnings RatioSuppose the market value of Asian Art, Inc., common stock is Rs15.75 on the last day of its fiscal yearCalculating the P/E ratio


Price/Earnings RatioSuppose the market value of Asian Art, Inc., common stock is Rs15.75 on the last day of its fiscal yearThe income statement reports EPS of Rs.92Calculating the P/E ratio


Price/Earnings RatioSuppose the market value of Asian Art, Inc., common stock is Rs15.75 on the last day of its fiscal yearThe income statement reports EPS of Rs.92What is Asian Arts price/earnings ratio?Calculating the P/E ratio


Price/Earnings RatioMarket value of stockEarnings per share

Price/Earnings RatioMarket value of stockEarnings per share

Rs15.75Rs.92

= 17.12

Dividend YieldRatio of dividends per share of stock to the stocks market valueIndicates the percentage of a stocks market value returned to the stockholder in the form of dividendsAssists investors who desire a steady flow of dividend revenue in their decisions to invest in a particular stock

Dividend YieldAnnual dividends per shareStocks market value per share

If Asian Art paid a total of Rs1.25 in dividends per share, what would be its dividend yield, assuming the same market value for its stock (Rs15.75)?


Rs1.25Rs15.75

= .079

Book ValueRelationship between common stockholders equity and number of common shares outstanding Measures the accounting value of one share of the corporations common stockDEBIT CREDIT

Book ValueTotal equity - preferred equity# of shares of common stock outstanding

The book value of one share of Lands End common stock is:

Rs201,192,00040,221,000 shares

= Rs5.00/share

Limitations of Financial AnalysisNo one ratio or years worth of financial information should be relied upon to provide a complete assessment of a corporations financial conditionAnalysts should:Examine trends over timeBenchmark to industry and key competitorsSeek answers about why ratios are different

The Complexity of Business DecisionsBusiness environment is complicated by numerous local, regional, national, and global issues - all must be considered when evaluating current financial condition or forecasting future potential for income

Economic Value Added - A New Measure of PerformanceMeasure of increase in stockholder wealth brought about by corporate operating activitiesReturns to the 2 providers of capitalInvestorsLendersshould exceed amount these providers charge the corporation to use their capital

Economic Value Added - A New Measure of PerformanceNet income +interest exp.

Economic Value Added - A New Measure of PerformanceNotes + loans +long-term debt +stockholdersequityxNet income +interest exp.

Economic Value Added - A New Measure of PerformanceNotes + loans +long-term debt +stockholdersequityxNet income +interest exp.Cost ofcapital

TIME TO REST

ATTENTION COMMERCE STUDENTSACCOUNTING(FINANACIAL & COST) OFICMAP STAGE 1,2,3,4 (NEW CLASSES)CA..MODULE B,C,DPIPFA (FOUNDATION,INTERMEDIATE,FINAL)ACCA-F1,F2,F3BBA,MBAB.COM(FRESH),M.COMMA-ECONOMICS..O/A LEVELSKHALID [email protected]

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