Dr Gourav Vallabh

Financial Statement Analysis

Dr Gourav Vallabh

XLRIJamshedpur

Dr Gourav Vallabh

FINANCIAL STATEMENT ANALYSIS

• The way to compare companies of different sizes is to use standard measures

• Financial ratios are standard measures that enable analysts to compare companies of different sizes

Dr Gourav Vallabh

• The objectives of financial statement analysis are to help investors– Predict their expected returns (see the

previous graph)– Assess the risks associated with those

returns

FINANCIAL STATEMENT ANALYSIS

Dr Gourav Vallabh

USING RATIOS TO MAKE BUSINESS DECISIONS

• A ratio expresses the relationship of one number to another

• The ratios used to make business decisions may be classified as follows:– Ratios that measure the company’s ability

to pay current liabilities– Ratios that measure the company’s ability

to sell inventory and collect receivables

Dr Gourav Vallabh

– Ratios that measure the company’s ability to pay long-term debt

– Ratios that measure the company’s profitability

– Ratios used to analyze the company’s stock as an investment

USING RATIOS TO MAKE BUSINESS DECISIONS

Dr Gourav Vallabh

MEASURING A COMPANY’S ABILITY TO PAY CURRENT

LIABILITIES

Working capital is defined as follows:

Working capital = Current assets - Current liabilitiesWorking capital = Current assets - Current liabilities

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• Working capital is widely used to measure a business’s ability to meet its short-term obligations with its current assets

• The larger the working capital, the better able is the business to pay its debts

MEASURING A COMPANY’S ABILITY TO PAY CURRENT

LIABILITIES

Dr Gourav Vallabh

CURRENT RATIO

• The current ratio– Is current assets divided by current

liabilities– Measures the ability of the company to pay

current liabilities with current assets

• The following slides give the comparative income statement and balance sheet of Palisades Furniture, Inc.

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PALISADES FURNITURE, INC.Comparative Income Statement

Year Ended December 31, 20X3 and 20X2

20X3 20X2

Net sales $858,000 $803,000Cost of goods sold 513,000 509,000Gross profit 345,000 294,000Operating expenses: Selling expenses 126,000 114,000 General expenses 118,000 123,000 Total operating expenses 244,000 237,000Income from operations 101,000 57,000Interest revenue 4,000 -0-Interest expense 24,000 14,000Income before income taxes 81,000 43,000Income tax expense 33,000 17,000Net income $ 48,000 $ 26,000

PALISADES FURNITURE, INC.Comparative Income Statement

Year Ended December 31, 20X3 and 20X2

20X3 20X2

Net sales $858,000 $803,000Cost of goods sold 513,000 509,000Gross profit 345,000 294,000Operating expenses: Selling expenses 126,000 114,000 General expenses 118,000 123,000 Total operating expenses 244,000 237,000Income from operations 101,000 57,000Interest revenue 4,000 -0-Interest expense 24,000 14,000Income before income taxes 81,000 43,000Income tax expense 33,000 17,000Net income $ 48,000 $ 26,000

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PALISADES FURNITURE, INC.Comparative Balance Sheet

December 31, 20x3 and 20X2

20X3 20X2AssetsCurrent assets: Cash $ 29,000 $ 32,000 Accounts receivable, net 114,000 85,000 Inventories 113,000 111,000 Prepaid expenses 6,000 8,000 Total current assets 262,000 236,000Long-term investments 18,000 9,000Plant, property and equipment, net 507,000 399,000Total assets $787,000 $644,000

LiabilitiesCurrent liabilities: Notes payable $ 42,000 $ 27,000 Accounts payable 73.000 68,000 Accrued liabilities 27,000 31,000 Total current liabilities 142,000 126,000Long term debt 289,000 198,000 Total liabilities 431,000 324,000

Stockholders’ EquityCommon stock, no par 186,000 186,000Retained earnings 170,000 134,000 Total stockholders’ equity 356,000 320,000 Total liabilities and stockholders’ equity $787,000 $644,000

PALISADES FURNITURE, INC.Comparative Balance Sheet

December 31, 20x3 and 20X2

20X3 20X2AssetsCurrent assets: Cash $ 29,000 $ 32,000 Accounts receivable, net 114,000 85,000 Inventories 113,000 111,000 Prepaid expenses 6,000 8,000 Total current assets 262,000 236,000Long-term investments 18,000 9,000Plant, property and equipment, net 507,000 399,000Total assets $787,000 $644,000

LiabilitiesCurrent liabilities: Notes payable $ 42,000 $ 27,000 Accounts payable 73.000 68,000 Accrued liabilities 27,000 31,000 Total current liabilities 142,000 126,000Long term debt 289,000 198,000 Total liabilities 431,000 324,000

Stockholders’ EquityCommon stock, no par 186,000 186,000Retained earnings 170,000 134,000 Total stockholders’ equity 356,000 320,000 Total liabilities and stockholders’ equity $787,000 $644,000

Dr Gourav Vallabh

The current ratio of Palisades Furniture, Inc., at December 31, 20X3 and 20X2, follow, along with the average for the retail furniture industry:

Current ratio =Current ratio = Current assetsCurrent assetsCurrent liabilitiesCurrent liabilities

$262,000$142,000

= 1.85 $236,000$126,000

= 1.87

Palisades’ Current Ratio

Industry Average = 1.70Industry Average = 1.70

20X3 20X2Formula

In general, a higher current ratio indicates a stronger financial positionIn general, a higher current ratio indicates a stronger financial position

In most industries a current ratio of 2.0 is

considered good

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• The acid-test (or quick) ratio – Indicates whether the entity could pay all

its current liabilities if they came due immediately

– Is computed by dividing cash, short-term investments, and net current receivables (accounts and notes receivable, net of allowances) by current liabilities

ACID TEST RATIO

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Palisades Furniture’s acid-test ratios for 20X3 and 20X2 are:

Acid-Test ratio =Acid-Test ratio =Cash + short-term Cash + short-term investments + net investments + net current receivablescurrent receivablesCurrent liabilitiesCurrent liabilities

$29,000 + $0 + $114,000

$142,000=1.01

$32,000 + $0 + $85,000

$126,000= 0.93

Palisades’ Acid-Test Ratio

20X3 20X2Formula

Industry Average = 0.40Industry Average = 0.40An acid-test ratio of 0.90to 1.00 is acceptable in

most industries

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MEASURING ABILITY TO SELL INVENTORY AND

COLLECT RECEIVABLES• Three ratios are presented that

measure the company’s ability to sell inventory and collect receivables– Inventory turnover– Accounts receivable turnover– Days’ sales in receivables

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INVENTORY TURNOVER

• Inventory turnover is – A measure of the number of times a

company sells its average level of inventory during a year

– Computed by dividing the cost of goods sold by the average inventory for the period

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• A high rate of turnover indicates relative ease in selling inventory; a low turnover indicates difficulty in selling

• In general, companies prefer a high inventory turnover

• Inventory turnover varies widely with the nature of the business

INVENTORY TURNOVER

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Palisades Furniture’s inventory turnover for 20X3 is:

Inventory turnover =Inventory turnover =Cost of goods soldCost of goods sold

Average inventoryAverage inventory

$513,000

$112,000 4.58=

Industry Average = 3.00Industry Average = 3.00

FormulaPalisades’ Inventory

Turnover

Palisades Furniture’s turnover of 4.58 times a year is high for its industry, which has an average turnover of 3.00

Palisades Furniture’s turnover of 4.58 times a year is high for its industry, which has an average turnover of 3.00

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ACCOUNTS RECEIVABLE TURNOVER

• Accounts receivable turnover– Measures a company’s ability to collect

cash from credit customers– Is computed by dividing net sales by

average net accounts receivable• The resulting ratio indicates how many times

during the year the average level of receivables was turned into cash

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• In general, the higher the ratio, the more successfully the business collects cash and the better off its operations

• A receivable turnover that is too high may indicate that credit is too tight, causing the loss of sales to good customers

ACCOUNTS RECEIVABLE TURNOVER

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Palisades’ Furniture’s accounts receivable turnover ratio for 20X3 is computed as follows:

Accounts Accounts receivable = receivable =

turnover turnover

Net credit salesNet credit sales

Average net Average net accounts receivableaccounts receivable

$858,000

$99,0008.62=

Industry Average = 31.3Industry Average = 31.3

FormulaPalisades’ Accounts Receivable Turnover

Palisades’ receivable turnover of 8.62 is much lower than the industry average, possibly because larger stores sell their receivables

Palisades’ receivable turnover of 8.62 is much lower than the industry average, possibly because larger stores sell their receivables

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DAYS’ SALES IN RECEIVABLES

• The days’-sales-in-receivables ratio tells– How many days’ sales remain in Accounts

Receivable– Is computed by a two-step process

• First, divide net sales by 365 days to figure the average sales amount for one day

• Second, divide this average day’s sales amount into the average net accounts receivable

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1. One day’s sales =1. One day’s sales =Net salesNet sales

365 days365 days

$858,000

365 days $2,351=

Industry Average = 2 daysIndustry Average = 2 days

FormulaPalisades’ Days’ Sales in

Accounts Receivable

The day’s sales in receivables for Palisades is higher (worse) than the industry average because the company collects its own receivables

The day’s sales in receivables for Palisades is higher (worse) than the industry average because the company collects its own receivables

Average net Average net accounts receivableaccounts receivable

Days’ sales in Days’ sales in average accounts = average accounts =

receivable receivable

2.2.

One days’ salesOne days’ sales$99,500$2,351

= 42 days

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MEASURING A COMPANY’S ABILITY TO PAY

LONG-TERM DEBT• Two indicators of a business’s ability to

pay long-term liabilities are the– Debt ratio– Times-interest-earned ratio

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DEBT RATIO

• The debt ratio tells the proportion of the company’s assets that it has financed with debt

• The higher the debt ratio, the higher the strain of paying interest each year and the principal amount at maturity

• The lower the ratio, the lower the business’s future obligations

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Calculation of the debt ratios for Palisades Furniture at the end of 20X3 and 20X2 is as follows:

Debt ratio =Debt ratio = Total liabilitiesTotal liabilitiesTotal assetsTotal assets

$431,000$787,000

= 0.55 $324,000$644,000

= 0.50

Palisades’ Debt Ratio

Industry Average = 0.64Industry Average = 0.64

20X3 20X2Formula

The company’s debt ratio indicates a fairly low-risk debt compared to the retail furniture industry average

The company’s debt ratio indicates a fairly low-risk debt compared to the retail furniture industry average

The average debt ratio for most companies

ranges from 0.57- 0.67

Dr Gourav Vallabh

MEASURING A COMPANY’S PROFITABILITY

• There are four rate-of-return measurements that help evaluate a company’s profitability:– Rate of return on net sales– Rate of return on total assets– Rate of return on common stockholders’

equity– Earnings per share of common stock

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RATE OF RETURN ON NET SALES

• The rate of return on net sales shows the percentage of each sales dollar earned as net income

• The higher the rate of return, the more net sales dollars are providing income to the business and the fewer net sales dollars are absorbed by expenses

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The rate-of-return-on-sales ratios for Palisades Furniture are calculated as follows:

Rate of return Rate of return on saleson sales

Net incomeNet income

Net SalesNet Sales $48,000$858,000

= 0.056 $26,000$803,000

= 0.032

Palisades’ Rate of Return on Sales

Industry Average = 0.008Industry Average = 0.008

20X3 20X2Formula

The increase in Palisades Furniture’s return on sales identifies the company as more successful than the average furniture store

The increase in Palisades Furniture’s return on sales identifies the company as more successful than the average furniture store

==

Dr Gourav Vallabh

RATE OF RETURN ON COMMON STOCKHOLDERS’

EQUITY• Rate of return on stockholders’ equity

(return on equity)– Shows the relationship between net

income and common stockholders’ investment in the company

– Is calculated by dividing net income available to common stockholders by the average stockholders’ equity during the year

Dr Gourav Vallabh

The rate of return on common stockholders’ equity for Palisades Furniture is calculated as follows:

Rate of return Rate of return on common on common

stockholders’ stockholders’ equity equity

Net Net incomeincome

Average common Average common stockholders’ equitystockholders’ equity

$48,000 - $0$338,000

= 0.142

Palisades’ 20X3 Rate of Return on Common

Stockholders’ Equity

Industry Average = 0.121Industry Average = 0.121

Formula

Preferred Preferred DividendsDividends--

==

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• Palisades’ return on equity (0.142) is higher than its return on assets (0.101).

• This difference results from borrowing at one rate (8%) and investing the funds to earn a higher rate (14.2%)

• This practice is called trading on the equity or using financial leverage

RATE OF RETURN ON COMMON STOCKHOLDERS’

EQUITY

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LIMITATIONS OF FINANCIAL ANALYSIS

• Ratios have their limitations

• Financial analysis may indicate that something is wrong, but it may not identify the specific problem or show how to correct it

• Managers must evaluate data on all ratios in the light of other information about the company

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• Ratios should be analyzed over a period of years

• Any one year, or even any two years, may not be representative of the company’s performance over the long term

LIMITATIONS OF FINANCIAL ANALYSIS