FINMAN 2 – FINANCIAL STATEMENTS ANALYSIS 5.

Summarize findings based on analysis and reach conclusions about firm relevant to
• Financial Statements - are structured representation of the financial position of and the the established objectives.
transactions undertaken by an enterprise.
• They provide information about the entity’s economic resources and the claims against • Horizontal analysis – is a percentage analysis of changes in comparative financial
the reporting entity, as well as the effects of transactions and other events that change a statements.
reporting entity’s economic resources and claims. Steps in conducting horizontal analysis:
• OBJECTIVE: to provide financial information about the reporting entity that is useful to 1. Compute the peso amount of the change from the base (earlier) period to the later
existing and potential investors, lenders and other creditors in making decisions about period, and
providing resources to the entity. (Conceptual Framework, IASB, September 2010) 2. Divide the peso amount of change by the base-period amount. This, however, is not
• Basic Financial Statements: done if the base year figure is negative or zero.
• Balance Sheet (Statement of Financial Position)
• Income Statement (Statement of Comprehensive Income) • Vertical Analysis – is a percentage analysis used to show the relationship of each
• Statement of Shareholders’ Equity component to the base total within a single statement.
• Statement of Cash Flows • Common Size Financial Statements – are statements which amounts were
• Notes to the Financial Statement translated from peso amounts to percentages, indicating the relative sizes of an item
• Financial Statement Analysis - is the process of extracting information from financial in proportion to the whole.
statements to better understand a company’s current and future performance and • Thus, common size balance sheet shows assets, liabilities and equity as a
financial condition. percentage of total assets, while common size income statements express revenue
• It involves: and expenses as a percentage of sales.
• Comparing the firm’s performance to that of other firms in the same industry Conversion Procedures
(cross-sectional analysis), and • For the balance sheet, each item therein is converted to percentage by dividing it by
• Evaluating trends in the firm’s financial position over time (time-series analysis). total assets.
• OBJECTIVE: to identify an organization’s financial strengths and weaknesses. • In income statement, each item is restated as a percentage of net sales by dividing
the former by the latter.
LIMITATIONS OF FINANCIAL STATEMENTS ANALYSIS:
• Information derived by the analysis are not absolute measures of performance in any INTERPRETATION GUIDELINES – BALANCE SHEET
and all of the areas of business operations. They are only indicators of degrees of • A common-size balance sheet shows the percent of total assets that has been
profitability and financial strength of the firm. invested in each type or kind of assets. These percentages may be compared with
• There are inherent limitations in the accounting data which the analyst is working with those of a competitor or the industry to determine whether or not the firm has over- or
brought about by (a) variation and lack of consistency in the application of accounting underinvested in one or more assets.
principles, policies and procedures, (b) too condensed presentation of data, and (c) • The common-size statement will also show the distribution of liabilities and equity,
failure to reflect change in purchasing power. i.e., the source of capital invested in the assets.
• Performance measures or tools and techniques (Quantitative Measurements) are not • The percentage of current assets may also be related to the percentage of current
absolute measures but should be interpreted relative to the nature of the business liabilities to determine the liquidity of the company.
and in the light of past, current and future operations.
• Analysts should be alert to the potential for management to influence the outcome of INTERPRETATION GUIDELINES – INCOME STATEMENT
financial statements in order to appeal creditors, investors and other stakeholders. • The common-size income statement shows the amount or percentage of the sales
STEPS IN ANALYZING FINANCIAL STATEMENTS: that has been absorbed by each individual cost or expense item and the percentage
1. Establish objectives of the analysis. that remains as net income.
2. Study the industry in which firm operates and relate industry climate to current and • Comparison of year-to-year income statement common-size ratios will show whether
projected economic development. a larger or smaller relative amount of net sales was used to meet particular costs or
3. Develop knowledge of the firm and quality of management. expenses.
4. Evaluate financial statements using any of the techniques below: • Comparison of the gross profit percentage from year-to-year may also reveal success
1. Horizontal Analysis/Index Analysis or failure efficiency in the procurement and merchandising policies.
2. Vertical Analysis
3. Financial Ratios
FINMAN 2 – FINANCIAL RATIOS LIQUIDITY RATIO
• Financial Ratio – is a comparison in fraction, proportion, decimal or percentage form of • Liquidity Ratio – measures the firm’s ability to pay off debts maturing within a year
two significant figures taken from financial statements. or within the next operating cycle.
• It expresses the direct relationship between two or more quantities in the statement of • Basic Liquidity Ratios:
financial position or statement of comprehensive income. • Current Ratio – measures the firm’s ability to meet its short-term obligations.
• It involves methods of calculating and interpreting financial ratios to analyze and monitor It is the primary test of solvency to meet current obligations using current
the firm’s performance. assets as a going concern, and it measures the adequacy of working capital.
USES OF FINANCIAL RATIOS – WITHIN THE FIRM • Formula:
• Identify deficiencies in a firm’s performance and take corrective action. Current Assets
• Evaluate employee performance and determine incentive compensation. Current Ratio=
Current Liabilities
• Compare the financial performance of the firm’s different divisions.
• Quick (Acid Test) Ratio – measures the firm’s ability to meet its short-term
• Prepare, at both firm and division levels, financial projections.
obligations using its “quick” assets. It severely tests the company’s
• Understand the financial performance of the firm’s competitors.
immediate ability to be solvent/liquid.
• Evaluate the financial condition of a major supplier.
• Formula:
USES OF FINANCIAL RATIOS – OUTSIDE THE FIRM
Cash+ Marketable Securities+ Accounts Receivables
• Financial ratios are used by: Quick ( Acid Test )Ratio=
• Lenders in deciding whether or not to lend to a company. Current Liabilities
• Credit-rating agencies in determining a firm’s credit worthiness. • Defensive Interval Ratio – measures the length of time in days the firm can
• Investors (shareholders and bondholders) in deciding whether or not to invest in operate on its present liquid resources
a company. • Formula:
• Major suppliers in deciding to whether or not to extend credit to a company Cash+ Marketable Securities+ Accounts Receivables
and/or in designing the specific credit terms.
Defensive Interval Ratio=
Average Daily Operating Expenses
CAUTIONS IN USING FINANCIAL RATIO ANALYSIS • FINANCIAL RATIOS
• It is sometimes difficult to identify industry categories or comparable peers. ACTIVITY RATIO
• Ratios that reveal large deviations from the norm merely indicate the possibility of a • Activity Ratio – measures the efficiency of the company in converting its resources
problem. into sales or cash (operations).
• A single ratio does not generally provide sufficient information from which to judge the • Basic Activity Ratios:
overall performance of the firm. One or two ratios, however, will suffice if analysis is • Accounts Receivable Turnover Ratio – measures the firm’s velocity of
concerned with certain specific aspects of the firm only. collection of trade accounts. This tests the company’s efficiency in collection of
• Ratios being compared should be calculated using financial statements dated at the accounts.
same point in time. • Formula:
• It is preferable to use audited financial statements for ratio analysis.
• The published peer group or industry averages are only approximations, thus industry
Net ( Credit ) Sales
A /R Turnover=
averages may not provide a desirable target ratio. Average Accounts Receivable∗¿ ¿
• Accounting practices differ widely among firms. A / R , Beg+ A / R , End
• Seasons may bias the numbers in the financial statements. ¿ Average Accounts Receivable=
2
• The financial data being compared should have been developed in a consistent manner.
• Days Sales Outstanding (also called as Average Collection Period or
• Inflation may distort ratio analysis results.
Average Age of Receivables)– measures the average number of days to collect
CATEGORIES OF FINANCIAL RATIO (PAL2MF)
a receivable. It is used to evaluate the company’s accounts receivable liquidity
• Liquidity Ratio
and its credit and collection policies.
• Activity Ratio
• Formula:
• Leverage Ratio
¿ of Days∈a Yr . Av g . AR
• Profitability Ratio Days Sales Out .= ∨
• Market Ratios ARTurnover Av g . Daily Net Sales∗¿ ¿
Net Credit Sales
¿ Average Daily Net ( Credit ) Sales=
Number of Days∈a Year
• Inventory Turnover Ratio – measures the firm’s efficiency in managing and selling its Net Sales
inventories. This ratio indicates if a firm holds excessive stocks of inventories that are Plant /¿ Asset Turnover=
Average Total Assets∗¿ ¿
unproductive and that lessens the company’s profitability.
Total Assets , Beg+Total Assets , End
• Formula: ¿ Average Total Assets=
Cost of Sales 2
Inventory Turnover= • Capital Intensity Ratio – measures the intensity of the company’s use of investment
Average Inventory∗¿ ¿ to generate revenue for the company.
Invty , Beg+ Invty , End • Formula:
¿ Average Inventory=
2 Average Total Assets
• Days Supply in Inventory (also called as Average Age of Inventory)– measures the Capital Intensity Ratio=
Net Sales
average number of days to sell or consume the average inventory.
LEVERAGE RATIO
• Formula:
• Leverage Ratio – measures how risky the firm is, the degree of use of debt facilities
¿ of Days∈a yr . Av g . Inventory
Days Supply ∈INV .= ∨ to finance resources and operations, and the company’s solvency.
Inv . Turnover Av g . Daily cos∗¿¿ • Basic Leverage Ratios:
Cost of Sales • Debt Ratio – measures the proportion of total assets financed with debt.
¿ Average Daily Cost of Sales= • Formula:
Number of Days∈a Year
• Accounts Payable Turnover Ratio – measures the firm’s efficiency in meeting its Total Liabilities
Debt Ratio=
accounts payable. Total Assets
• Formula: • Equity Ratio – measures the proportion of total assets financed with equity.
Net ( Credit ) Purchases • Formula:
Accounts Payable Turnover= '
Average Accounts Payable∗¿ ¿ Total Shareholder s Equity
Equity Ratio= ∨1−Debt Ratio
AP, Beg+ AP, End Total Assets
¿ Average Accounts Payable= • Debt to Equity Ratio – measures debt relative to amounts of resources
2
• Average Payment Period (also called as Average Age of Payables)– measures the provided by owners. It provides a comparison of percentage of resources
average number of days a company pays its accounts payable. It determines whether the provided by the creditors against those provided by the business owners.
company is paying its invoices on a timely basis. It is used to evaluate the company’s • Formula:
payment policies. Total Liabilities
Debt ¿ Equity Ratio= '
• Formula: Total Shareholder s Equity
¿ of Days∈a Year Av g . AP • Times Interest Earned Ratio – measures the firm’s ability to make
Ave . Payment Period= ∨
APTurnover Ave . Daily Net Purchases∗¿ ¿ contractual interest payments. It measures how many times interest expense
Net Credit Purchases is covered by operating profit.
¿ Average Daily Net ( Credit ) Purchases= • Formula:
Number of Days∈a Year Operating Profit / EBIT
• Plant/Fixed Asset Turnover Ratio – measures the level of use of property, plant and ¿ Interest Earned Ratio=
equipment in operations. It is used to test roughly the efficiency of management in Interest Expense
keeping plant properties employed. • Fixed Payment Coverage Ratio – measures the firm’s ability to meet all fixed
• Formula: payment obligations. This simply expands the coverage of times interest earned ratio
Net Sales by including other fixed payments.
Plant /¿ Asset Turnover= Assets∗¿ • Fixed charges – defined as payments other than interest expenses that have fixed
Average¿ determinable payments on a periodic basis (e.g. Lease payments, sinking bond
¿ Assets , Beg+¿ Assets , End payments).
¿ Average ¿ Assets=
2 • Formula:
• Investment/Asset Turnover Ratio – measures the firm’s efficiency in using its Operating Profit +¿ Charges
available resources (assets) to generate sales. ¿ Payment Coverage Ratio=
Interest Expense +¿ Charges
• Formula:
 • Financial Leverage Multiplier (Equity Multiplier) – measures the extent to Net Profit
which the company uses debt in financing asset investment. Returnon Investment =
Average Total Assets
• Formula:
OR
( Average ) Assets Returnon Investment = Asset Turnover X Net Profit Margin
Financial Leverage Multiplier=
( Average ) Equity • Return on Equity – measures the return earned on the shareholders’
• Operating Leverage Factor (Degree of Operating Leverage) – measures investment in the firm.
the extent to which a company uses fixed costs in its cost structure. It also a • Formula:
measure of the risk of profitability of an entity given the volatility of sales Net Profit
volume. Returnon Equity=
Average Ordinary Equity
• Formula: OR
Contribution Marging Returnon Equity=Return on Investment X Financial Leverage Ratio∗¿
Operating Leverage Factor=
Operating Profit Average Total Asset
PROFITABILITY RATIO
*
Financial Leverage Ratio=
Average Ordinary Equity
• Profitability Ratio – measures how profitable the company is in its operations and MARKET RATIO
usage of resources.
• Market Ratio – relates the firm’s market value, as measured by its current share
• Basic Profitability Ratios:
price, to certain accounting values. It gives insight into how investors in the
• Gross Profit Margin – measures the proportion of earnings to the sales after
marketplace feel the firm is doing in terms of risk and return.
the cost of sales were paid.
• Basic Market Ratios:
• Formula:
• Price/Earnings Ratio – measures the amount that investors are willing to
Gross Profit pay for each dollar of a firm’s earnings. The level of this ratio indicates the
Gross Profit Margin=
Net Sales degree of confidence of the investors in the company’s future performance.
• Operating Profit Margin – measures the proportion of earnings to the sales • Formula:
after all costs expenses other than interest and taxes were paid. Market Price Per Share
• Formula: Price/ Earnings Ratio=
Earnings Per Share
Operating Profit • Market/Book Ratio – provides an assessment of how investors view the
Operating Profit Margin=
Net Sales firm’s performance. It relates the market value of the firm’s share to its book
• Net Profit Margin – measures the proportion of earnings to the sales after all value.
costs expenses were paid. • Formula:
• Formula: Market Price per Share
Net Profit Market /Book Ratio=
Net Profit Margin= Book Value per Share
Net Sales • Dividend Yield Ratio – shows the rate earned by shareholders from
• Earnings Per Share – measures the peso return on each ordinary share. It dividend relative to current price of stock.
reflects the company’s earning power, i.e. its ability to generate profit from • Formula:
normal operations. Dividend per Share
• Formula: Dividend Yield Ratio=
¿ Market Price per Share
Earnings Per Share=Net Profit Attributable ¿ Common Stockholders • Dividend Payout Ratio – shows the percentage of earnings paid to
Average Common Stock Outstanding shareholders.
• Return on Investment (or Return on Asset) – measures the overall • Formula:
effectiveness of the management in generating profits with its available
Dividend per Share
assets. This ratio indicates whether the management is using the available Dividend Payout Ratio=
funds or investment wisely in the operations Earnings per Share
• Formula: DUPONT SYSTEM OF ANALYSIS
• DuPont System of Analysis – used to dissect the firm’s financial statements and to
assess its financial condition.
• It merges the income statement and balance sheet into two summary measures of
profitability, the ROA and the ROE.
• The DuPont system first brings together the net profit margin, which measures the firm’s
profitability on sales, with its total asset turnover, which indicates how efficiently the firm
has used its assets to generate sales.
ROI=Net Profit Margin X Total Asset Turnover
• The modified DuPont Formula relates the firm’s return on total assets to its return on
common equity. The latter is calculated by multiplying the return on total assets (ROA) by
the financial leverage multiplier (FLM)
ROE=Returnon Investment X Financial Leverage Multiplier