CHAPTER 9 Financial statement analysis I. Contents The purpose of analysis Traditional analysis ...

Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts

CHAPTER 9Financial statement analysis I


Contents

The purpose of analysis Traditional analysis Tools of analysis Analysing financial statements


The purpose of analysis

Different groups of financial statement users with different information needs Focus will be on needs of equity

investors and suppliers of credit Differing levels of technical expertise

Focus on tools used by a sophisticated user


The purpose of analysis (cont.)

Primary questions relate to company performance and financial strength, but user emphasis may differ Investment analysts are primarily interested in

financial statements as a predictor of future performance

Lenders will primarily focus on the financial strength (default risk)

Each question is the sum of different issues


Traditional analysis

Basis of traditional analysis is relevant comparison

Comparison over time or in space Time series analysis: comparing

company performance over time Cross-sectional analysis: comparing

company performance with other companies in the same industry (or industry average)


Time series analysis

Horizontal analysis Using a multi-year information base Trend percentages

Select a base year Set item amounts of that year = 100% Corresponding amount of each following

year = % of base mount Impact of inflation


Time series analysis- Illustration

Trend percentages of total sales (2000 = 100%)

2005 2004 2003 2002 2001 2000

Sales (€million)

617 583 492 413 627 445

Sales – trend %

139% 131% 111% 93% 141% 100%


Cross-sectional analysis Comparison with other companies in

the same industry for the same year Differences in company characteristics

should always be accounted for in interpretation

Comparison with industry averages Multi-product companies Definition and size of industry groupings


Tools of analysis

Common-size financial statements Use of financial ratios Management performance ratios Financial strength ratios


Common-size financial statements

Standardizing financial statements by introducing a common denominator

In a common-size balance sheet each component of the balance sheet is expressed as a percentage of total assets

In a common-size income statement each item is expressed as a percentage of sales


Common-size financial statements (cont.)

Allow comparison of companies of different size (in terms of total assets and sales)

Allow (internal) structural analysis of the financial statements of a company Relative magnitude of asset, liability, equity

and income statement components Combination of horizontal and vertical

analysis


Common-size balance sheet - Illustration

Published Common size

€m %

Assets

Fixed assets

Tangible assets 113.9 22.4

Investments 8.6 1.7

Current assets

Inventories 53.2 10.5

Receivables 218.6 43

Bank 114.3 22.4

Totals 508.6 100 Liabilities and equity

Trade and related liabilities 111.6 22

Short-term borrowing 201.3 39.6

Long-term borrowing 3.1 0.6

Provisions 24.1 4.7

Equity 168.5 33.1 Totals

508.6 100


Common-size income statement - Illustration

Published €m

Common size %

Sales 5,356 100 Cost of sales (2,601) (48.6) 2,755 51.4 Distribution costs (382) (7.1) Administrative expenses (874) (16.3) Profit before interest and tax 1,499 28.0 Interest (362) (6.8) Profit before taxation 1,137 21.2 Taxation (384) (7.1) Net profit for the period 753 14.1


Use of financial ratios A financial ratio expresses the mathematical

relationship between two or more financial statement items that are logically linked

Comparison over time and in space Like must always be compared with like

Combined use of financial ratios is more informative

Financial ratios as indicators of management performance and financial strength


Management performance ratios

Profitability and asset utilization ratios Margin ratios (return on sales) show how

successful management is in creating profit from a given quantity of sales

Return on investment ratios take into account the investment needed to generate the profit

Asset utilization ratios measure how efficient management uses the company’s assets


Table 9.1 Profitability ratiosNet profit after tax Net profit margin = Sales

Sales less Cost of sales Gross operating margin = Sales

Net profit before interest and tax Net operating margin = Sales

Net profit after tax Return on equity (ROE) = Equity

Net profit before interest Return on assets (ROA) = Total assets

Net profit after tax + (interest * (1-tax rate)) = Total assets

Net profit before interest on LT-debt Return on capital employed (ROCE) = Equity + LT-debt

Net profit after tax Earnings per share (EPS) = Number of shares outstanding


Margin ratios

Main ratios: Gross operating margin Net operating margin Net profit margin

Measure operating efficiency Tend to be highly industry-specific


Return on investment ratios Main ratios:

Return on equity (ROE) Return on assets (ROA) Return on capital employed (ROCE)

Each reflects the profit generated by a specific pool of funds, excluding the costs of the specific funds considered

Different denominators (investment base) and numerators (profit figure retained)


ROI - perspectives ROE measures how much a company has

earned on the funds invested by its shareholders (shareholder perspective)

ROA shows how well a company’s funds were used, irrespective of the relative magnitudes of the sources of these funds (current liabilities, debt and equity)

ROCE shows how much a company has earned on invested long-term funds (permanently employed capital = equity + LT debt)


Figure 9.1 Capital employedAssets Financing

Fixed assetsEquity

Net working capitalLT Debt

Current assetsCurrent liabilities

Cap

ital em

plo

yed

Cap

ital e

mp

loyed


Earnings per share (EPS) Shows how much of a period’s net profit has

been earned by each ordinary share outstanding (basic EPS) or by shares outstanding plus all potential shares (diluted EPS)

Potential shares are equity instruments issued that can be converted into ordinary shares at the option of the holder of the instrument

IAS 33 Earnings per Share requires that listed companies disclose both basic and diluted EPS on the face of the income statement


Price/earnings ratio

Price/Earnings =

Market price per share

EPS

EPS is used as input to a market ratio, the price/earnings or P/E ratio:

•Reflects how the market (market price) judges the company’s performance (growth expectations)

•It is an inverted rate of return ratio

•Also called the Earnings Multiple


Dividend yield ratio

Dividend Yield =Dividend per share

Market price per share

The dividend yield ratio reflects the relationship between the dividends per share paid to shareholders and the current market price of a share:

Both P/E and dividend yield ratios of listed companies are published daily by major financial newspapers


Asset utilization ratios

Main ratios: Total asset turnover Fixed asset turnover Inventory turnover Receivable turnover

Turnover ratios measure efficiency of use of (categories of) assets

Tend to be industry-specific


Table 9.1 Asset utilization ratios

Sales Total asset turnover =

Total assets

Sales Fixed asset turnover =

Fixed assets

Cost of sales Inventory turnover =

Inventories

(Net credit) Sales Receivables turnover =

Receivables


Financial strength ratios Indicate the strength of a company’s

financial position from the point of view of long-term solvency risk and short-term liquidity risk

Solvency refers to the long-term ability to generate cash internally or from external sources in order to meet long-term financial obligations

Liquidity refers to the ability to generate cash to meet short-term obligations


Long-term solvency risk ratios

Main ratios: Debt/equity ratio Gearing ratio Interest and dividend cover

Gearing as indicator of default risk Debt financing introduces financial risk

because it implies fixed commitments in the form of interest payments and principal repayment and exposure to interest rate movements


Table 9.2 Long-term solvency risk ratios

Debt Gearing (Debt/equity ratio) = Equity

This ratio is also frequently computed on the basis of debt to total finance:

Debt Gearing (Total finance) = Debt + Equity

Profit before interest and tax Interest cover = Net interest charges

Earnings per share Dividend cover = Dividend per share


Short-term liquidity risk ratios

Main ratios: Current ratio and acid-test ratio Credit given and credit obtained Days inventory outstanding

Liquidity tests focus on the make-up of working capital and the activity level of its components

Low liquidity implies financial risk as inability to service short-term debt payments may lead to higher interest expense and, eventually, bankruptcy


Table 9.2 Short-term liquidity risk ratios

Current assets Current ratio = Current liabilities

Current assets – Inventories Acid test (or quick ratio) = Current liabilities

Inventories Days inventory

outstanding = Cost of sales * 365 days

Similarly:

Receivables Credit given = (Credit) Sales

* 365 days

Trade payables Credit obtained redit obtained = Cost of sales * 365 days


Analysing financial statements

Decode messages built into financial statements and use them to ‘tell the story’

Time series analysis of ratios Combine patterns of financial ratios Compare cross-sectionally Ratio analysis is only part of an investment

appraisal process - also consider: Non-financial performance indicators Broader economic variables Information about future business plans, etc.


Worked example (1)

20X7 20X8 20X9 €’000 €’000 €’000

Income statements:

Sales

620.0 745.0 762.0 Cost of sales -217.0 -245.8 -266.7 Gross Margin 403.0 499.2 495.3 Distribution costs -204.6 -260.7 -266.7 Administrative expenses -95.1 -97.2 -101.4 103.3 141.3 127.2 Interest -10.0 -30.9 -37.5 93.3 111.3 98.7 Taxation -32.7 38.9 -31.4 60.6 72.4 67.3


Worked example (2) Balance sheets: 20X7 20X8 20X9 €’000 €’000 €’000

Net fixed assets

312.0

532.0

495.0 Inventories 43.4 49.2 66.7 Receivables 62.0 74.5 91.4 Cash 67.0 70.3 58.0 484.4 726.0 711.1 Ordinary shares (€1) 120.0 120.0 120.0 Reserves 195.5 267.9 315.2 315.5 387.9 435.2 Debt 100.0 250.0 200.0 Trade payables 36.2 49.2 44.5 Taxes payable 32.7 38.9 31.4 484.4 726.0 711.1


Worked example (3) 20X7 20X8 20X9 Management Performance ratios

A. Profitability ratios ROE 60.6 / 315.5 72.4 / 387.9 67,3 / 435.2 =19.21% =18.66% =15.46%

ROA (60.6+(10*(1-0.3)))/

484.4 (72.4+(30.9*(1-0.3)))

/726 (67.3+(37.5*(1-0.3)))

/711.1 =13.96% =12.95% =13.16%

ROCE (60.6+(10*(1-0.3)))/

(315.5+100) (72.4+(30.9*(1-0.3)))/

(387.9+250) (67.3+(37.5*(1-0.3)))/

(435.2+200) =16.27% =14.74% =14.73% EPS 60.6/120 72.4/120 67.3/120 =50.50 =60.33 =56.08 Gross operating margin (620-217)/620 (745-245.8)/745 (762-266.7)/762 =65.00% =67.01% =65.00% Net operating margin 103.3/620 141.3/745 127.2/762 =16.66% =18.97%% =16.69% Net profit margin 60.6/620 72.4/745 67.3/762 =9.77% =9.72% =8.83%


Worked example (4)

20X7 20X8 20X9

B. Asset utilization ratios Total asset turnover 620/484.4 745/726 762/711.1 =1.28 =1.03 =1.07

Fixed asset turnover 620/312 745/532 762/495 =1.99 =1.40 =1.54 Inventory turnover 217/43.4 245.8/49.2 266.7/66.7 =5.00 =5.00 =4.00 Receivables turnover 620/62 745/74.5 762/91.4 =10.00 =10.00 =8.34


Worked example (5) 20X7 20X8 20X9 Financial strength ratios A. Long-term solvency risk ratios Gearing 100/315.5 250/387.9 200/435.2 =31.70% =64.45% =45.96% Gearing (Total finance) 100/(100+315.5) 250/(250+387.9) 200/(200+435.2) =24.07% =39.22% =31.49% Interest cover 103.3/10 141.3/30.9 127.2/37.5 =10.33 =4.57 =3.39 Dividend cover 60.6/20.0 72.4/20.0 67.3/20 =3.03 =3.62 =3.37


Worked example (6) 20X7 20X8 20X9

B. Short-term liquidity ratios

Current ratio (43.4+62+67)/

(36.2+32.7) (49.2+74.5+70.3)

/(49.2+38.9) (66.7+91.4+58.0)

/(44.5+31.4) =2.50 =2.20 =2.85

Acid test (62+67)/

(36.2+ 32.7) (74.5+70.3)/ (49.2+38.9)

(58.0+91.4)/ (31.4+44.5)

=1.87 =1.64 =1.97

Days inventory outstanding (43.4/217)*365 (49.2/245.8)*365 (66.7/266.7)*365

=73.00 =73.06 =91.28 Credit given (62/620.0)*365 (74.5/745)*365 (91.4/762)*365 =36.50 =36.50 =43.78 Credit obtained (36.2/217.0)*365 (49.2/245.8)*365 (44.5/266.7)*365 =60.89 =73.06 =60.90


Worked example (7)

Growth: 20x7/ x8 20x8/ x9 Sales 20.16% 2.28% Profit 19.47% -7.04% Capital employed 53.53% -0.42% Net fixed assets 70.51% -6.95%

CHAPTER 9 Financial statement analysis I. Contents The purpose of analysis Traditional analysis ...

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