FINANCIAL STATEMENT ANALYSIS Ing. Markéta Šeligová, Ph.D. MANAGERIAL ACCOUNTING/NANMU FINANCIAL STATEMENT ANALYSIS OUTLINE OF THE LECTURE 1. Techniques of financial statement analysis 2. 2. Liquidity 3. 3. Asset management 4. 4. Debt management 5. 5. Profitability 6. 6. 1. FINANCIAL STATEMENT ANALYSIS INTRODUCTION •stockholders, creditors, and managers are examples of stakeholders that use financial statement analysis to evaluate a company´s financial health and future prospects • •stockholders and creditors analyze a company´s financial statements to estimate its potential for earnings growth, stock price appreciation, making dividend payments, and paying principal and interest on loans; managers use financial statement analysis for two reasons • –first, it enables them to better understand how their company´s financial results will be interpreted by stockholders and creditors for the purposes of making investing and lending decisions • –second, financial statement analysis provides managers with valuable feedback regarding their company´s performance FINANCIAL STATEMENT ANALYSIS THREE ANALYTICAL TECHNIQUES OF FINANCIAL STATEMENT ANALYSIS Three analytical techniques are widely used • •dollar and percentage changes on statements (horizontal analysis) • •common-size statements (vertical analysis) • •ratios • FINANCIAL STATEMENT ANALYSIS DOLLAR AND PERCENTAGE CHAGNES ON STATEMENTS •horizontal analysis (also known as trend analysis) involves analyzing financial data over time, such as computing year-to-year dollar and percentage changes within a set of financial statements • •the dollar changes highlight the changes that are the most important economically • •the percentage changes highlight the changes that are the most unusual • •horizontal analysis can be even more useful when data from a number of years are used to compute trend percentages • •to compute trend percentages, a base year is selected and the data for all years are stated as a percentage of that base year FINANCIAL STATEMENT ANALYSIS COMMON-SIZE STATEMENTS •horizontal analysis examines changes in financial statement accounts over time • •vertical analysis focuses on the relations among financial statement accounts at a given point in time • •a common-size financial statement is a vertical analysis in which each financial statement account is expressed as a percentage • •in income statements, all items are usually expressed as a percentage of sales • •in balance sheets, all items are usually expressed as a percentage of total assets FINANCIAL STATEMENT ANALYSIS RATIO ANALYSIS – LIQUIDITY (1) •liquidity refers how quickly an asset can be converted to cash • •liquid assets can be converted to cash quickly, whereas ill-liquid assets cannot • •companies need to continuously monitor the amount of their liquid assets relative to the amount that they owe short-term creditors, such as suppliers • •if a company´s liquid assets are not enough to support timely payments to short-term creditors, this presents an important management problem that, if not remedied, can lead to bankruptcy FINANCIAL STATEMENT ANALYSIS RATIO ANALYSIS – LIQUIDITY (2) – WORKING CAPITAL •the excess of current assets over current liabilities is known as working capital • working capital = current assets - current liabilities • •managers need to interpret working capital from two perspectives • •on one hand, if a company has ample working capital, it provides some assurance that the company can pay its creditors in full and on time; on the other hand, maintaining large amounts of working capital isn´t free • •working capital must be financed with long-term debt and equity - both of which are expensive FINANCIAL STATEMENT ANALYSIS RATIO ANALYSIS – LIQUIDITY (3) – CURRENT RATIO (1) FINANCIAL STATEMENT ANALYSIS RATIO ANALYSIS – LIQUIDITY (4) – CURRENT RATIO (2) •an improving ratio might be the result of stockpiling inventory, or it might indicate an improving financial situation • •the general rule of thumb calls for a current ratio of at least 2 • •however, many companies successfully operate with a current ratio below 2 • •the adequacy of a current ratio depends heavily on the composition of assets • FINANCIAL STATEMENT ANALYSIS RATIO ANALYSIS – LIQUIDITY (5) - ACID-TEST (QUICK) RATIO FINANCIAL STATEMENT ANALYSIS RATIO ANALYSIS – ASSET MANAGEMENT (1) – ACCOUNTS RECEIVABLE TURNOVER (1) FINANCIAL STATEMENT ANALYSIS RATIO ANALYSIS – ASSET MANAGEMENT (2) – ACCOUNTS RECEIVABLE TURNOVER (2) FINANCIAL STATEMENT ANALYSIS RATIO ANALYSIS – ASSET MANAGEMENT (3) – INVENTORY TURNOVER (1) FINANCIAL STATEMENT ANALYSIS RATIO ANALYSIS – ASSET MANAGEMENT (4) – INVENTORY TURNOVER (2) FINANCIAL STATEMENT ANALYSIS RATIO ANALYSIS – ASSET MANAGEMENT (5) – OPERATING CYCLE (1) •the operating cycle measures the elapsed time from when inventory is received from suppliers to when cash is received from customers • Operating cycle = Average sale period + Average collection period • •a manager´s goal is to reduce the operating cycle because it puts cash receipts in the company´s possession sooner • •in fact, if a company can shrink its operating cycle to fewer days than its average payment period for suppliers, it means the company is receiving cash from customers before it has to pay suppliers for inventory purchases FINANCIAL STATEMENT ANALYSIS RATIO ANALYSIS – ASSET MANAGEMENT (6) – TOTAL ASSET TURNOVER (1) FINANCIAL STATEMENT ANALYSIS RATIO ANALYSIS – ASSET MANAGEMENT (7) – TOTAL ASSET TURNOVER (2) •a company´s goal is to increase its total asset turnover • •to do so, it must either increase sales or reduce its investment in assets • •if a company´s accounts receivable turnover and inventory turnover are increasing but its total asset turnover is decreasing, it suggests the problem may relate to noncurrent asset utilization and efficiency FINANCIAL STATEMENT ANALYSIS RATIO ANALYSIS – DEBT MANAGEMENT (1) •managers need to evaluate their company´s debt management choices from the vantage point of two stakeholders - long-term creditors and common stockholders • •long-term creditors are concerned with a company´s ability to repay its loans over the long-run. • •stockholders look at debt from a financial leverage perspective • •financial leverage refers to borrowing money to acquire assets in an effort to increase sales and profits • •a company can have either positive or negative financial leverage depending on the difference between its rate of return on total assets and the rate of return that it must pay its creditors • FINANCIAL STATEMENT ANALYSIS RATIO ANALYSIS – DEBT MANAGEMENT (2) • •if the company´s rate of return on total assets exceeds the rate of return the company pays its creditors, financial leverage is positive • •if the rate of return on total assets is less than the rate of return the company pays its creditors, financial leverage is negative FINANCIAL STATEMENT ANALYSIS RATIO ANALYSIS – DEBT MANAGEMENT (3) – TIMES INTEREST EARNED RATIO (1) FINANCIAL STATEMENT ANALYSIS RATIO ANALYSIS – DEBT MANAGEMENT (4) – TIMES INTEREST EARNED RATIO (2) • •interest expenses are deducted before income taxes are determined; creditors have first claim on the earnings before taxes are paid • •a times interest earned ratio of less than 1 is inadequate because interest expense exceeds the earnings that are available for paying the interest • •in contrast, a times interest earned ratio of 2 or more may be considered sufficient to protect long-term creditors FINANCIAL STATEMENT ANALYSIS RATIO ANALYSIS – DEBT MANAGEMENT (5) – DEBT-TO-EKVITY RATIO (1) FINANCIAL STATEMENT ANALYSIS RATIO ANALYSIS – DEBT MANAGEMENT (6) – DEBT-TO-EKVITY RATIO (2) •creditors and stockholders have different views about the optimal debt-to-equity ratio • •ordinarily, stockholders would like a lot of debt to take advantage of positive financial leverage • •on the other hand, because equity represents the excess of total assets over total liabilities, and hence a buffer of protection for creditors, creditors would like to see less debt and more equity • •in practice, debt-to-equity ratios from 0,0 (no debt) to 3,0 are common –in industries with little financial risk, managers maintain high debt-to-equity ratios –in industries with more financial risk, managers maintain lower debt-to-equity ratios FINANCIAL STATEMENT ANALYSIS RATIO ANALYSIS – DEBT MANAGEMENT (7) – EQUITY MULTIPLIER (1) • •the equity multiplier is another type of leverage ratio that indicates the portion of a company´s assets funded by equity • •similar to the debt-to-equity ratio, as the equity multiplier increases, it indicates that a company is increasing its financial leverage • •in other words, it is relying on a greater proportion of debt rather than equity to fund its assets • FINANCIAL STATEMENT ANALYSIS RATIO ANALYSIS – DEBT MANAGEMENT (8) – EQUITY MULTIPLIER (2) FINANCIAL STATEMENT ANALYSIS RATIO ANALYSIS – PROFITABILITY (1) •managers pay close attention to the amount of profits that their companies earn • •however, when analyzing ratios, they tend to focus on the amount of profit earned relative to some other amount such as sales, total assets, or total stockholder´s equity • •when profits are stated as a percentage of another number, such as sales, it helps managers draw informed conclusions about how the organization is performing over time FINANCIAL STATEMENT ANALYSIS RATIO ANALYSIS – PROFITABILITY (2) – GROSS MARGIN PERCENTAGE FINANCIAL STATEMENT ANALYSIS RATIO ANALYSIS – PROFITABILITY (3) – NET PROFIT MARGIN PERCENTAGE FINANCIAL STATEMENT ANALYSIS RATIO ANALYSIS – PROFITABILITY (4) – RETURN ON TOTAL ASSETS FINANCIAL STATEMENT ANALYSIS RATIO ANALYSIS – PROFITABILITY (5) – RETURN ON EQUITY FINANCIAL STATEMENT ANALYSIS RATIO ANALYSIS – MARKET PERFORMANCE (1) – EARNINGS PER SHARE FINANCIAL STATEMENT ANALYSIS RATIO ANALYSIS – MARKET PERFORMANCE (2) – PRICE-EARNINGS RATIO FINANCIAL STATEMENT ANALYSIS RATIO ANALYSIS – MARKET PERFORMANCE (3) – DIVIDEND PAYOUT AND YIELD RATIOS (1) •investors in a company´s stock make money in two ways - increases in the market value of the stock and dividends • •in general, earnings should be retained in a company and not paid out in dividends as long as the rate of return on funds invested inside the company exceeds the rate of return that stockholders could earn on alternative investments ouside the company • •companies with excellent prospects of profitable growth often pay little or no dividend • •companies with little opportunity for profitable growth, but with steady, dependable earnings, tend to pay out a higher percentage of their cash flow from operations as dividends FINANCIAL STATEMENT ANALYSIS RATIO ANALYSIS – MARKET PERFORMANCE (4) – DIVIDEND PAYOUT AND YIELD RATIOS (2) FINANCIAL STATEMENT ANALYSIS RATIO ANALYSIS – MARKET PERFORMANCE (5) – DIVIDEND PAYOUT AND YIELD RATIOS (3) FINANCIAL STATEMENT ANALYSIS RATIO ANALYSIS – MARKET PERFORMANCE (6) – DIVIDEND PAYOUT AND YIELD RATIOS (4)