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CHAPTER 3CHAPTER 3
FINANCIAL STATEMENTFINANCIAL STATEMENT
ANALYSIS TOOLSANALYSIS TOOLS
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OBJECTIVESOBJECTIVES
Discuss and interpret the analysis tools of financial statement.
Apply several basic financial statement major ratios and techniques.
Identify the relevant analysis information beyond financial statements.
Explain the types of equity or valuation analysis methods.
Analyze the ways to use the ratio and caution using the financial
tools.
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FINANCIAL ANALYSIS TOOLSFINANCIAL ANALYSIS TOOLS
The basic tools are:
± Comparative financial statement
Horizontal Analysis
Trend Index Analysis
± Common size financial statement
± Ratio analysis Profitability analysis
Credit Analysis
Equity Analysis and Evaluation
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Comparative Financial Statement
Analysis
Comparative financial statement analysis involves a review of changes in
individual account balances on year-to-year or multiyear basis.
The most important information often revealed from a comparative financial
statement analysis is trend . referred to as horizontal analysis.
HORIZONT AL AN ALYS I S: ± Shows the changes between years in the financial data in both amount and percentage form.
AMOUNT CH ANGE = C URRENT Y EAR ± B ASE Y EAR
TREND INDEX AN ALYS I S: ± Trend percentages state several years¶ financial data in terms of a base year, which equals
100 percent
T rend index = Current Year Amount X 100
Base Year Amount
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ABC Corp
BASE YEAR
CURRENT YEAR
Income statements Fiscal year ended December 31
(RM in millions)
2007 2006 Change
analysis
%
Net sales
Cost of goods sold
1,938.0
1,128.5
1,766.2
1,034.5
Gross operating profit 809.5 731.7
Selling, administrative, and other operating expenses
Depreciation & authorization
Other income, net
497.777.1
0.5
445.362.1
12.9
Earnings before interest & taxes 234.2 237.2
Interest expense 13.4 7.3
Earning before taxes 221.8 229.9
Income taxes 82.1 88.1
Net profit after tax
Dividends paid per share
Earnings per share (EPS)
Number of common shares
outstanding ( in millions)
138.7
0.15
2.26
61.8
116.0
0.13
2.17
65.3
Base year Current
year
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Common Size Analysis
Done by proportioning a group or subgroup of the items in the
account . Also called v ertical analysis. Common size financial
statement analysis is useful to understand the internal make up of a
company including the:
± Distribution of financing across liabilities and utilization of assets (for common size
balance sheet) and
± Distribution of expenses and profit over sales (for common size income statement)
There are two types of common size analysis:
± common size income statement
± common size balance sheet.
Specifically in analyzing balance sheet, it is common to express total asset (or
liabilities plus equity) as 100%. Then, accounts within these groupings are
expressed as a percentage of their respective totals.
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ABC Corp
Comparative Balance Sheet
December 31
(RM in millions)
2007 Common size
analysis
Assets
Current assets
Cash
Receivables
Inventories
Other current assets
95.8
227.2
103.7
73.6
Total current Assets 500.3
N oncurrent Assets
Gross Property, plant, & equipment
Accumulated depreciation & depletion
Net Property, plant, & equipmentOther noncurrent assets
771.2
(372.5)
398.7
42.2
Total Noncurrent assets 440.9
Total Assets
Liabilities and Stockholders¶ Equity
Current liabilities
Account payable
Short-term debt
Other current liabilities
941.2
114.2
174.3
85.5
100%
Total Current liabilities 374.0
N oncurrent liabilities
Long-term debt
Other noncurrent liabilities
177.8
94.9
Total noncurrent liabilities 272.7
Total liabilities
S tockholders equity
Common shares
Retained earnings
646.7
92.6
201.9
Total equity 294.5Total Liabilities and Stockholders¶ equity
941.2 100%
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ABC Corp
Income statements
Fiscal year ended December 31
(RM in millions)
2007 Common size
analysis
Net sales
Cost of goods sold
1,938.0
1,128.5
100%
Gross operating profit 809.5
Selling, administrative, and other operatingexpenses
Depreciation & authorization
Other income, net
497.777.1
0.5
Earnings before interest & taxes 234.2
Interest expense 13.4
Earning before taxes 221.8
Income taxes 82.1
Net profit after tax
Dividends paid per share
Earnings per share (EPS)
Number of common shares outstanding ( in
millions)
138.7
0.15
2.26
61.8
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R atio Analysis
Analyzed to identify the company's strengths and
weaknesses and useful insights can be gained
through the process.
Classifications of ratio that the most commonly
used are:
± Liquidity ± Debt (or Leverage)
± Activity (or Turnover)
± Profitability
± Market ratio
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Liquidity Ratio
Determine a company's ability to pay off its short-terms
debts obligations.
Generally, the higher the value of the ratio, the larger
margin of safety that the company possesses to cover its
short-term debts
It can give a sense of the efficiency of a company'soperating cycle or its ability to turn its product into
cash.
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i) Current Ratio
Measures a company's ability to pay short-term
obligations.
Current R atio = Current Assets
Current Liabilities
Example: Current ratio for ABC corp in 2007 = 500.3 = 1.34
374.0T his figures indicate that ABC had RM 1.34 in short-ter m resources to
ser v ice ev ery dollar of current debt. S uggest that the company has
more than enough current asset to cov er it¶s current liability .
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ii) Acid-Test Ratio
The most stringent liquidity test as it indicates whether a
firm has enough short-term assets to cover its immediate
liabilities without selling inventory.
= ( Cash + Accounts R ecei v able + S hort-ter m Inv est ments)
Current Liabilities
or = T otal Current Asset - Inv entory
Current Liabilities
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iii) Working Capital
Measure of both a company's efficiency and its short-term financial
health. It frequently used to derive the working capital ratio, which is
working capital as a ratio of sales.
W orking Capital = Current Assets ± Current Liabilities
± P ositi v e working ca pital means that the company is able to pay off
its short-ter m liabilities.
± N egati v e working ca pital means that a company currently is
unable to meet its short-ter m liabilities with its current assets (i.e.
cash, accounts recei v able and inv entory).
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iV) Working Capital Turnover
Measure, which compares the depletion of
working capital to the generation of sales over a
given period. This provides some useful
information as to how effectively a company isusing its working capital to generate sales.
W orking Ca pital T urnov er =_____S ales____
W orking Ca pital
the higher the working capital turnover, the better because it
means that the company is generating a lot of sales compared to
the money it uses to fund the sales.
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Leverage Ratio
i) Debt Ratio
Indicates the proportion of debt a company has
relative to its assets. The measure gives an ideato the leverage of the company along with the
potential risks the company faces in terms of its
debt-load.
T otal Debt = T otal Debt T otal Assets
A debt ratio of greater than 1 indicates that a company has more debt
than assets; meanwhile, a debt ratio of less than 1 indicates that a
company has more assets than debt.
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ii) Debt/Equity Ratio Measure of a company's financial leverage calculated by dividing its Long
Term liabilities by stockholders' equity. Debts to Equity ratio also were used
to measure ³Capital Structure´ of a company.
Debt/ E quity R atio = Long T er m Debt
S hareholders¶ E quity
A high debt/equity ratio generally means that a company has been
aggressive in financing its growth with debt. This can result in volatile
earnings as a result of the additional interest expense.
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Activity Ratio
i) Inventory turnover Inventory include the raw materials, work-in-process
goods and completely finished goods
Inventory Turnover = Cost of a Good Sold Average Account Receivables
Example: IT = RM 1,938.0 = 18.69
RM 103.7
T he more sales the company can get out of its inv entory, the better the return on this
v ital resource. A turnov er of al most 19 ti mes a year means that the fir m is holding
inv entory for less than a month ± actually for about 20 days (365/18.9 = 19.5. T he
higher the turnov er figure, the less ti me an item s pends in inv entory and the better the
return the company is able to earn from funds tied u p in inv entory.
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ii) Receivables Turnover Ratio
Number of times that accounts receivable amount
is collected throughout the year.
Accounts Receivable Turnover = Sales___________
Average Accounts Receivable
Some companies' reports will only show sales - this can
affect the ratio depending on the size of cash sales.
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Profitability Ratio
Profitability analysis is a financial metrics that are used
to assess a business's ability to generate earnings as
compared to its expenses and other relevant costs
incurred during a specific period of time.
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Profit Margin
It measures how much out of every dollar of
sales a company actually keeps in earnings.
P rofit M argin = N et Income/ N et P rofit
R ev enue/ S ales
A higher profit margin indicates a more profitable
company that has better control over its costs
compared to its competitors.
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ii) Return on Asset (ROA)
An indicator of how profitable a company is
relative to its total assets. ROA gives an idea as
to how efficient management is at using its assets
to generate earnings.
R eturn on Asset ( ROA ) = N et Income
T otal Assets
ROA tells you what earnings were generated from invested capital
(assets).
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iii) Return on Equity (ROE)
A measure of a corporation's profitability that
reveals how much profit a company generates with
the money shareholders have invested.
R eturn on E quity ( ROE ) = N et Income________
S hareholder¶s E quity
The ROE is useful for comparing the profitability of a
company to that of other firms in the same industry.
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DuPont Method
DuP ont M ethod is a method of analysis that breaks down return on equity into the sources
of that profitability. T he method is named for
the company that originally conducted the
analysis.
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(1) (2) (3)
Net Profit
Margin
X Total Asset
Turnover
= Return On
Investment
Net income
Net sales
X Net sales
Total assets
= Net income
Total assets
(3) (4) (5)
Return On
Investment
X Financial
Leverage
= Return On
Equity
Net income
Total assets
X Total assets
Stockholders¶
equity
= Net income
Stockholders¶
equity
The first three ratios reveal that the (3) return on investment (profit generated from the overall
investments in assets) is a product of the (1) net profit margin (profit generated from the sales)
and the (2) total asset turnover (the firm¶s ability to produce sales from its assets). Extending
the analysis, the remaining three ratios show how the (5) return on equity (overall return to
shareholders, the firm¶s owners) is derived from the product of (3) return on investment and (4)
financial leverage (proportion of debt in the capital structure).
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Sources of Company¶s Profit
It is possible to break down the return on equity
(ROE) ratio into several smaller parts. This is
useful because there are five ways for a company
to increase its profits. Four of these ways are
captured in the following equation:
M argin x T urnov er x Le
v erage x T ax effect = ROE
E .B.T x S ales x T otal Assets x 1 ± tax rate = ROE
S ales T otal Assets E quity
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COMPANY STRATEGY«.
± Improve its profit margin by doing a better job of controlling
costs and pricing its products appropriately
± Increase its turnover through leverage on the use of effective
advertising, branding, sales promotions, and training of its
sales force.
± Increases leverage by utilizing bit more to finance the company.
± Reduce the amount of taxes paid as a result of effective
tax planning (although this is generally the least important of the
four factors).
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Investors would rather invest in a company that
is:
± Performing very well in the operations area
(purchasing, production, working etc.) and which is
conservatively financed (i.e., has a low level of debt),
rather than
± Performing very poorly in the operations area and is
very aggressively financed (i.e., has a high level of
debt)?
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HOW TO USE RATIO«.
There are two primary ways to use financial ratios:
± Compare a ratio's value over several periods of
time (trend analysis or time-series analysis). If we
see a deteriorating trend in any ratio's values over severalquarters or years, we can investigate to find the cause.
± Compare the company's ratios to the industry
average (cross-sectional analysis). A single ratio value
by itself usually means nothing - we need a standard, or benchmark , to compare it to. This benchmark is usually the
industry average (i.e., the ratio's average value for all firms in the
industry).
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Cautions in Using Ratios
Ratios don't prove that a problem exists or provide definite answers to any of our questions
Realize that there may be significant differences between the characteristics
of the company and the "average" firm in the industry
Always make sure that you are calculating a ratio exactly as the industry
average ratio is calculated.
Companies frequently don't have the same fiscal year
Companies' accounting practices may differ considerably.
Be careful about depending too much on any one ratio.
Audited financial statements should be used whenever possible.
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END OF CHAPTER 3
TIME TO TEST YOUR UNDERSTANDING«.«.
Get into your group and lets do this exercise !!!!