FINANCIAL STATEMENTS ANALYSIS: Learning Objectives 1. Understand the objectives of financial statement analysis, and its limitations, 2. Use the analytical techniques in financial statements analysis: a, Horizontal analysis b. Trend analysis Vertical analysis 4. Ratio analysis, 3. Prepare and interpret common- size financial statements, 4. Compute the various financial ratios, turnover and their interpretations and how to use them for profit planning. ae ee LPS rane an EAaER RENN EES Introduction Financial statements provide the basic source of information by managers and other interested Parties outside the organization regarding its financial conditions and results of operations. Financial statements communicate the firm's financial strengths and weaknesses as well as its performance for the current period. Though financial statements are primarily prepared for extemal users (Stockholders, investors, government agencies, etc), managers find it equally useful for their making decisions such as performance evaluation, developing operating plans and any other matters related to their operating activities. Although financial statements are based on historical accounting information, which reflects transactions and other events that affected the firm, it would help the users in predicting future, as. indicated by the trend analysis. A potential lender or investor could assess the company's overall financial strength, income and growth potential as well as the financial effects on some matters that required future decisions. The company's ability to repay obligations and distribution of returns on investments are the primary concerns of the potential lenders and investors. Overview of Financial Statements The four key financial statements are: 1. Balance Sheet ~ the purpose ofthe balance sheet isto present a summary of the assets owned by firm, its liabilities, and its net financial position at a given point in time. The assets are often referred to as investments and the liabilities and owner's equity as financing. 2. Income Statement - provides a financial summary of a company’s operating results during a specified period. : 3. Cash Flow Statement - provides a summary of the firm's operating, investment, and financing cash flows and reconciles them with changes in its cash and marketable securities during the perio. It also tes together the income statement and previous and current balance sheets, 4, Statement of Retained Earnings - reconciles the net income earned during a given year, and any cash dividends paid, with the change in retained earnings between the start and the end of that year.‘Chapter 2 Financial Statements Analysis ‘The basic structure of each of these statements and their relationships: FINANCIAL STATEMENT RELATIONSHIPS Balance Sheet Balance Sheet Beginning (12-31-x1) Ending (12.3132) Libis Liabilities ASSETS = + ASSETS = ' Capital Capital “Transactions daring the period From 12-3L-x1 to 12-31-32 Income Statement For the yearended Dec. 31, 20:2 Revenues eamed /Gains Cash Flow Statement For the year ended Dec. 31, 2032 Cash balance beginning + Cash inflows in 2052 = Cash outflows in 2052 =_—Cash balance cading _ Cash balance 12-31-32 Cash balance 123texl__ =a In this chapter, analysis will be focused on these two statements, balance sheet and income statements. The most widely used techniques in financial statement analysis are: 1. Comparative analysis a. horizontal analysis b. trend analysis c. vertical analysis 2. Ratio or Component analysis including turnovers. Cautions About Financial Statements Analysis Managers should look beyond the ratios. They should consider the technological changes, industry trends, consumer tastes and various economic factors. Here are some cautions about using financial ratios:(Ghoplor2 Financial Stotoments Anayais 00 . Ratios that reveal large deviations from the norm merely indicate the possibility of a problem. .A.single ratio does not generally provide enough information from which to judge the overall performance ofthe firm, 3, The ratios being compared should be calculated using financial statements dated at the same point in time during the year, 4. Itis preferable to use audited financial statements. 5, The financial data being compared should have been developed in the same way. 6. Results can be distorted by inflation. Comparative Analysis An item on a financial statement has little meaning by itself. The meaning of the numbers can be enhanced by drawing comparisons. Percentage changes and relative ratios are widely used in comparative and trend analyses. Horizontal analysis is comparing two periods and becomes trend analysis if extended to three or more periods having the earliest year as the base period. Vertical analysis, also known as common-size statements is analysis of the component parts of a single statement in a given period. The analyst must have in mind that these percentage changes and ratios are only indicators of the performance or financial condition of the company: No single measure could tell us more. To give ‘a more meaningful interpretation, these financial measures must be compared between periods and between other companies within the same industry but, most preferably, a comparison between companies of the same size and capacities. Using the industry norm or standards could also add sense to the interpretation, Horizontal Analysis Horizontal analysis is a technique for evaluating a series of data over a period time to determine the increase or decrease that has taken place, expressed as either an amount ora percentage. The peso changes (increase or decrease) are normally presented in each item as well as their percentage changes. ‘Quantifying peso changes over time serves to highlight the changes that are the most important economically. Quantifying percentage changes over time serves to highlight the changes that are the most unusual. The following simple rules should be observed: 1. Tocompute forthe peso changes, current year less prior year, To compute for the percentage changes, peso change divided by the prior year (serve as the base figure). If there is no amount in prior year, no percentage change will be shown, as a matter of rule in mathematics, 3. To compute for the ratio presentation, current year divided by the prior year. Again, ifthe base year is zero of no amount in prior year, no ratio will be shown in the analysis, thus, peso amount presentation is important.Meine uke ogi JAMES CORPORATION COMPARATIVE BALANCE SHEET DECEMBER 31, Year 2 and Year 1 Changes, Increase (Decrease) Peso Year2 | Year1_| Amount | % | Ratio ‘ASSETS Current Assets: Cash. 2400] 2,100 300] 143%! 14 Marketable Securities 1,350 900 450| 500%] 150 Accounts Receivable, net 36000} 33,000} 3,000] 9.1%] 109 Inventory 60,000] 51,000] 9,000] 176%) 118 Prepaid Expenses 750 900, (150) | -16.7% | _ 0.83 Total Current Assets 100,500 | 87,900 | 12,600 14.3% | 1.14 Long-Term Investments 1,500. 1,650 (150) | -9.1%] 0.91 Property and Equipment Land 18,000 18,000 * 0.0% 1.00 Building net 165,000 | 156,000) 9,000] 58%] 1.06 Equipment, net 75,000| _69,000| 6000] 87% | 1.09 Total Property and 258,000 | 243,000 [15,000] 62% | 1.06 Equipment TOTAL ASSETS 360000 332550 27450 8.3% 1.08 LIABILITIES & STOCKHOLDERS’ EQUITY ‘Current Liabilities: ‘Accounts Payable 22500) 21,150} 1350) 64%} 1.06 Accrued Expense 6,600) 6,300 300] 48%} 1.05 Notes Payable 10,900| 8,700] 2.200| 253%] 1.25 Total Current Liabilities 40,000 | 36,150 3,850 [107% | 1.17 Long Term Liabilities 110,000 { _108,000|___2,000} 1.9% | 1.02 Total Liabilities 150,000] 144.150 [5,850 [41% | 1.04 Stockholders’ Equity Preferred Stock, P100 par,8% | 18,000] 18,000 -| 00%] 1.00 Common Stock, P10 par value | 75,000] 72,000] 3000| 42%| 1.04 ‘Additional paid in Capital 12,000/ 11,400 600} 53%) 1.05 Retained Earnings 105,000 | _87,000| _18,000| 20.7%} 1.21 Total Stockholders’ Equity [ 210,000 | 188,800 21,600 | 11.5% | 1.1 TOTAL LIABILITIES & STOCKHOLDERS’ EQUITY | 360,000] 332,550] 27450| 8.3% | 1.08(chaoor2 Financial ' 5 JAMES CORPORATION COMPARATIVE INCOME AND RETAINED EARNINGS STATEMENT FOR THE YEARS ENDED DECEMBER 31, Year 2 and Year 1 Changes Increase (Decrease) Peso Year2 | Year1 | Amount % Ratio Net Sales 261,000} 246,000] 15,000] 61%) 1.06 Cost of Sales 182790 | 169,050 13,740| 8.1%! 1.08 Gross Profit 78210| 76,950 1,260} 1.6%) 1.02 Operating Expenses, 21,000 | _ 20,100 900| 45%] 7.04 Net Operating Income 57,210 | 56,850 360) 06%) 1.01 Interest Expenses 12,090 | 11,670 420| 3.6% | 1.04 Net Income Before Tax 5,120] 45180| (60)| 01%] 100 ‘Tax Expense 11280| 11400| @20)|_ 11%} 0.99 | Net Income 33840 | 33,780 0} 02%) 1.00 Add Retained Earnings, beg. | _87,000| 68460| 18540] 271% | 1.27 | Total 720840 [102,240 | 18,600| 182% | 1.18 | Dividends 15840| 15240| 600 39%| 108 | Retained Earnings, ending 105,000 | _ 87,000 18,000 | 20.7% | 1.21 Net Operating Income 33,840 | 33,780 60) 02%] 1.00 Dividends to Preferred 1440 1440 =| 0.0%| 1.00 | Stock Net Income Available to 32400 | 32340 0} 0.2%] 1.00 Common | Dividends to Common 14400 | 13,800 600| 43%] 108 Stock Net Income 1800 [18540 | (G40) | -29%| 097 JAMES CORPORATION COMPARATIVE INCOME AND RETAINED EARNINGS STATEMENT FOR THE YEARS ENDED DECEMBER 31, Year? and Year 1 COMMON SIZE PRESENTATION Year1 | Year2 | Year2 | Yeari Net Sales, 261,000 246,000 100.0% | 100.0% Less Cost of Sales 182,700| _ 169,050| 70.0% | 68.7% Gross Profit 720| — 76950| 300% | 31.3% Less, Operating Expenses 2000| 20,100] 8.0% 8.2% Net Operating Income 57210| 56850] 21.9% | 23.1% Less, Interest Expenses 12090| _11670| 46%| 4.7% | Net Income 45,100| 45180| 173% | 184% Less, Tax Expense 11280| 11400] 43% | 46% Net Income 33840| _33,780| 13.0% | 13.7%hs 2 Pro Sonn Abt ATION JAMES: CORPORY | COMPARATIVE ‘COMMON For the balance sheet, Total Assets and Total Liabilities & Capital are both: considered 100% and rear item in the particular section are presented as a certain percent of the total. In James Corporation, Cash is 78% of total assets while Accounts Payable represents 6.3% of total Iiabilties and stockholders’ equity.hae 2Eranc Steers ie ic . Each item in the i > For the Income Statement, Net Sales : aes li Set en oe statement represents a certain percent of sal sales. Ratio Analysis it lyst develop his interpretation as to the Many rated ie i the bla 2 Financia statements report both the fins ratn pn nom fom ta Tab of fal cee is in the fact that they can be used to ree Saeed fire ‘earnings and dividends, thus, an analysis of the firm's ratios is ee EL i kabenent Sehnts, Ee lysis, ‘The ratios are designed to show relationships between sale eo Fe indance, Company X might have debt of P5 milion and intrest charges of PAKH Housand, while Compary Y ght have debt of P50 million and interest charges of PA mi in Wh ep nary & stronger? The true burden of these debts, and the companies’ ability to pay cn etna (1) by comparing each firm’s debt to its assets and (2) by comparing a ie Se He income it has available for payment of interest. Such comparisons are w1 . ‘The three major areas that concer the users of financial statements are 1. Stability 2. Solvency or liquidity, and 3. Profitability. Analyzing ratios as a whole could be more meaningful, even though they are computed individually the totality of it could give the final interpretation about the company's financial and operating conditions. The following are the most common ratios used by financial analysts: ‘Analyzing the Balance Sheet A. Liquidity Ratios These are ratios that show the relationship of the company’s cash and other current assets to its current liabilities. Liquidity is the number one concern of most financial analysts, This will indicate whether the firm can meet its maturing obligations. ‘The most common liquidity ratios and their procedural computations are: 1. Working Capital = Current assets minus current liabilities This is the excess of current assets over current liabilities, To some, working capital is used to designate current assets only as the amount intended for day to day operations of the business. Thus, the use of the term net working capital is more appropriate. The bigger the net working capital the better as it would mean more current assets are available for operations. 2. Current Asset Ratio = Current assets divided by current liabilities This is the basic test of liqui idity of the firm. This will determine the of working capital or the ability tom iinaael Bt et current obligations. The higher the current asset ratio, thebetter, as this would mean there are more current assets available for paying its current obligations. 3, Quick (Acid) Test Ratio = Quick assets divided by current liabilities Quick or acid test ratio is a more stringent test of ability to pay current obligations as they come due. Quick assets are: Cash and cash equivalents, marketable securities, short-term notes and accounts receivables. In this regard, inventory and prepaid expenses are not included in the computation of quick asset ratio as inventories are typically least liquid among the current assets, while, prepaid expenses are not convertible to cash. Though the analyst must do a careful analysis since accounts receivable could be converted into cash later than inventory. It is in the case of aged accounts receivable which are normally considered as bad debts. The opposite could be observed wherein inventory can be converted to cash earlier than accounts eile in the case of cash sales. The higher the quick asset ratio, the better liquidity position of the firm. ‘Asset Management Ratios. ‘These are set of ratios, which measures how effectively a firm is managing its assets. ‘These ratios are also called asset utilization ratio, which pertains to how effectively the firm utilized its assets to earn profits, ‘These ratios are designed to answer questions like: + Does the total amount of each type of asset as reported on the balance sheet seem maintained at a reasonable level? Will too high or too low current assets in relation to the projected or actual operating levels affect profitability? Normally companies borrow or.obtain capital from other sources to acquire assets. Ifa company has too many assets acquired through borrowings the intrest expenses willbe to0 high and, hence the profits will be Tower. On the other hand, if assets are too low, profitable sales may be lost. Therefore, managing these assets, particularly current assets will help the firm avoid borrowing funds to finance operations. The most common asset management ratios are: 1. Accounts Receivable Turnover = Netsales on account divided by average A/R* *Average A/R= (Beg + End) divided by 2 ‘This will measure the efficiency of collections. How fast collections are being made. Whenever possible, monthly balances of accounts receivable is used in determining average ‘accounts receivable. The net sales used as numerator are assumed to be all credit sales only, ‘The higher the turnover, the better, this would mean a greater number of times receivable is reinvested for more profit. 2. No.of daysin A/R or Average collection period ‘= 365 days( in a year) divided by AR Turnover