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CHAPTER 10
Financial Statement Analysis
Overview
• Liquidity measures
• Activity measures
• Accounts receivable and inventory turnover
• Profitability measures
• Price earnings ratio and evaluation of share
market price
• Dividend yield and dividend payout ratio
• Financial leverage
• Common size financial statements
• Other operating statistics
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Financial Statement Ratios
Ratios are used to interpret the financial
position and results of operations of an entity
and may be grouped in the following four
categories:
1. Liquidity
2. Activity
3. Profitability
4. Debt, or financial leverage
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Liquidity Measures
The liquidity measures of working capital, current
ratios and quick ratios were discussed in
Chapter 3.
Remember: The effect of the inventory cost-flow
assumption on:
FIFO
Specific
identification
Weighted
average
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working capital
and
current ratios
10-4
Liquidity Measures
Suppliers and creditors
Is the firm paying its
bills promptly?
What is the firms
current and recent
payment experience?
May be indicated by extent
that cash discounts are
being taken.
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Activity Measures
Focus primarily on relationships between asset
levels and net sales. The general model for
calculating turnover is:
Turnover = Sales ÷ Average Assets
Average assets use balance sheet amounts
reported at the beginning and end of a period.
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Activity Measures
Turnover is often used in the calculation
for assessing activity of:
• accounts receivable
• inventories
• plant and equipment
• total operating assets
• total assets.
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Activity Measures
Turnover ratios will be affected by inventory costflow assumptions and depreciation methods:
FIFO and accelerated
depreciation
$ inventory
$ depreciable
assets
Higher asset turnover
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Weighted-average
and straight line
depreciation
$ inventory
$ depreciable
assets
Lower asset turnover
10-8
Activity Measures
Amounts for 2004
Cash
These amounts
will be used to
demonstrate how
the ratios can be
calculated.
$
30,000
Accounts receivable, net
Beginning of year
17,000
End of year
20,000
Inventory
Beginning of year
10,000
End of year
12,000
Total current assets
65,000
Total current liabilities
42,000
Sales
500,000
Cost of goods sold
140,000
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Accounts Receivable Turnover
Accounts
Receivable =
Turnover
=
Sales
Average Accounts Receivable
$500,000
($17,000 + $20,000) ÷ 2
=
27.03 times
A measure of how many times a company converts
its receivables into cash each year.
Or average collection period of 13.5 days.
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Inventory Turnover
Inventory
Turnover
=
Cost of Goods Sold
Average Inventory
=
$140,000
($10,000 + $12,000) ÷ 2
= 12.73 times
A measure of the number of times merchandise
inventory is sold and replaced during the year.
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Inventory Turnover
Lower inventory compared to sales means less
needs to be financed by debt or equity.
BUT…
• risk of not having enough inventory to meet
demand
• risk of out of stock situation with delay in
receiving raw materials or finished product
and lost sales.
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Inventory Turnover
Inventory management system
JIT - Just in time:
• Keep the investment in
inventories at a minimum by
forecasting needs.
• Suppliers deliver inventories
only when needed.
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Activity Measures
In evaluating the firm’s operating efficiency, it
is the trend of these calculations over time that
is important.
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Profitability Measures
Discussed in Chapter 3:
• Return on assets (ROA)
• Return on equity (ROE).
Points to remember:
• ROA is based on EBIT (earnings before interest and tax)
• better measure of management activities as
• interest is a function of capital structure
• tax is a function of the tax laws.
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Profitability Measures
Need to maintain healthy scepticism about:
relationship?
True rate
of return
• Based on:
• real economic
profit related to
ROA and
ROE
No agreement on
how to determine
these
• fair market
values
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Profitability Measures
Evaluations more valid when based on the trend
of one company’s ROA and ROE relative to:
Trends in
industry
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Trends of
competitors
10-17
Price/Earnings Ratio
Price earnings
ratio
=
Market price per ordinary share
Earnings per share
Primary Health Care Ltd 30 June 2003
Closing market price per share
$4.10
Earnings per share
$0.13
Price earnings
ratio
=
$4.10
$0.13
= 32.7 times
A measure often used by investors to evaluate the market
price of a company’s ordinary shares.
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Price/Earnings Ratio
Investors’ expectations
about the firm’s future
earnings
Market price of
a share
Relating market price and earnings per share in
a ratio (price earnings ratio) is a way to express
investors’ expectations
The greater the probability of increased earnings, the
more investors are willing to pay.
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Price/Earnings Ratio
Company A
Company B
$45.00
$63.00
$1.80
$3.50
25
18
Market price per share
Earnings per share
Price / Earnings Ratio
At first glance, company B shares look more expensive,
but company A shares are more expensive as investors
are willing to pay 25 times earnings for the shares,
compared with 18 times for company B.
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Dividend Yield
Dividend
=
yield
Dividends per share
Market price per share
Cruisers Ltd 30 June 2006
Closing market price of share
$ 60.00
Annual cash dividend
1.45
Dividend
$1.45
=
= 2.4%
Yield
$60.00
Identifies the return, in terms of cash dividends, on the current
market price of the shares.
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Dividend Payout Ratio
Dividend
=
payout ratio
Annual dividend per share
Earnings per share
Cruisers Ltd 30 June 2006
Annual dividend per share
$
Earnings per share
Dividend
=
Payout Ratio
1.45
5.64
$1.45
= 25.7%
$5.64
Reflects the dividend policy of the company. Investors are
able to project future dividends based on a company’s
earnings prospects.
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Financial Leverage
Financial leverage refers to the use of debt to
finance the assets of the entity.
Leverage adds risk - if there is not enough
cash to pay principal and interest, entity may
be forced into bankruptcy.
BUT, as the cost of debt is fixed, leverage also
magnifies the return to owners (ROE) relative
to the return on assets (ROA).
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Financial Leverage
Borrowing at an interest rate that is less than
the rate of return that can be earned on that
money, multiplies the return on owners’
equity.
Debt and preference shares provide leverage
opportunities as the interest cost or dividend
rate is fixed.
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Financial Leverage - Debt Ratio
Debt ratio =
Total liabilities
Total liabilities + Owners’ equity
Total owners' equity
60,000
Total liabilities
40,000
Total liabilities plus
owners' equity
Debt ratio
=
100,000
$40000
$100000
= 40%
Measures the proportion of assets being provided by
creditors.
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Financial Leverage - Debt/Equity Ratio
Debt/Equity
=
ratio
Total liabilities
Total owners’ equity
Debt/Equity
=
ratio
$40000
$60000
= 67.0%
Measures the relative proportion of
contribution from owner’s and creditor’s.
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Financial Leverage - Times Interest Earned
Times interest
earned =
Earnings before interest and taxes
interest expense
Cruisers Ltd 30 June 2006 ($000)
Net profit before income tax
$3,209
Add back interest expense
$3,378
EBIT
$6,587
Times interest
earned
=
$6587
3378
= 1.95 times
A common measure of the ability of a firm to cover
interest and provide protection to the long-term
creditors.
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Common Size Financial Statements
Each asset
expressed as a %
of total assets
BALANCE SHEET
Current Assets
Non Current Assets
TOTAL ASSETS
100%
Current Liabilities
Non Current Liabilities
TOTAL LIABILITIES
Each liability and
equity account
expressed as a %
of total
OWNERS' EQUITY
TOTAL LIABILITIES
AND OWNERS' EQUITY
100%
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Common Size Financial Statements
INCOME STATEMENT
Sales
100%
Cost of goods sold
Gross profit
Operating expenses:
Selling
General & admin
Borrowing costs
Other income
Net profit from ordinary
activities before income tax
Income tax expense
Net profit
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Each item on the
Income Statement
expressed as a %
of total sales
This type of analysis
makes spotting trends
easier.
10-29
Other operating statistics
Statistics other than financial ratios may be
used to evaluate a firm.
• Sales in units
• Total number of employees
• Sales dollar per employee
• Operating income per employee
• Plant operating expenses per square metre of plant
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10-30