FINANCIAL

MANAGEMENT
FINANCIAL ANALYSIS

Prepared by:
Rusty C. Soramillos

INTRODUCTION
Financial analysis is a process of selecting, evaluating, and interpreting
financial data, along with other pertinent information, in order to formulate an
assessment of a companys past, present and future financial condition and
performance.

Market Data

Financial
Disclosures

Economic
Data

Financial Analysis
2

USER OF FINANCIAL ANALYSIS

Internal User
(Management)
Planning, evaluating and controlling company operations
External User
(Investors, creditors, regulatory agencies & stock market analysts and
auditors)
Assessing past performance and current financial position and making
predictions about the future profitability and solvency of the company as well
as evaluating the effectiveness of management

1. COMMON-SIZE ANALYSIS
Common-size analysis is the restatement of financial statement information in
a standardized form.
- Horizontal common-size analysis uses the amounts in accounts in a
specified year as the base, and subsequent years amounts are stated as a
percentage of the base value.
- Useful when comparing growth of different accounts over time.
- Vertical common-size analysis uses the aggregate value in a financial
statement for a given year as the base, and each accounts amount is
restated as a percentage of the aggregate.
- Balance sheet: Aggregate amount is total assets.
- Income statement: Aggregate amount is revenues or sales.

EXAMPLE: COMMON-SIZE ANALYSIS

Consider the CS Company, which reports the following financial information:
Year
Cash
Inventory
Accounts receivable
Net plant and equipment
Intangibles
Total assets

2008
P400.00
1,580.00
1,120.00
3,500.00
400.00
P6,500.00

2009
P404.00
1,627.40
1,142.40
3,640.00
402.00
P6,713.30

2010
P408.04
1,676.22
1,165.25
3,785.60
404.01
P6,934.12

2011
P412.12
1,726.51
1,188.55
3,937.02
406.03
P7,162.74

2012
P416.24
1,778.30
1,212.32
4,094.50
408.06
P7,399.45

2013
P420.40
1,831.65
1,236.57
4,258.29
410.10
P7,644.54

1. Create the vertical common-size analysis for the CS Companys assets.

2. Create the horizontal common-size analysis for CS Companys assets, using
2008 as the base year.

EXAMPLE: COMMON-SIZE ANALYSIS

Vertical Common-Size Analysis:
Year
Cash
Inventory
Accounts receivable
Net plant and equipment
Intangibles
Total assets

2008 2009 2010 2011 2012 2013

6%
6%
5%
5%
5%
5%
23% 23% 23% 23% 22% 22%
16% 16% 16% 15% 15% 15%
50% 50% 51% 51% 52% 52%
6%
6%
5%
5%
5%
5%
100% 100% 100% 100% 100% 100%

Graphically:
100%
Proportion
of Assets

50%
0%

2008

2009

2010

2011

2012

2013

Fiscal Year
Cash
Net plant and equipment

Inventory
Intangibles

Accounts receivable

EXAMPLE: COMMON-SIZE ANALYSIS

Horizontal Common-Size Analysis (base year is 2008):
Year
Cash
Inventory
Accounts receivable
Net plant and equipment
Intangibles
Total assets

2008
100.00%
100.00%
100.00%
100.00%
100.00%
100.00%

2009
101.00%
103.00%
102.00%
104.00%
100.50%
103.08%

2010
102.01%
106.09%
104.04%
108.16%
101.00%
106.27%

2011
103.03%
109.27%
106.12%
112.49%
101.51%
109.57%

2012
104.06%
112.55%
108.24%
116.99%
102.02%
112.99%

2013
105.10%
115.93%
110.41%
121.67%
102.53%
116.53%

Graphically:
Percentage
of Base
Year
Amount

130%
110%
90%
2008

2009

2010

2011

2012

2013

Fiscal Year
Cash

Inventory

Accounts receivable

Net plant and equipment

Intangibles

Total assets
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2. FINANCIAL RATIO ANALYSIS

Financial ratio analysis is the use of relationships among financial statement
accounts to gauge the financial condition and performance of a company.
We can classify ratios based on the type of information the ratio provides:

Activity Ratios

Liquidity
Ratios

Effectiveness
in putting its
asset
investment to
use.

Ability to meet
short-term,
immediate
obligations.

Solvency
Ratios

Profitability
Ratios

Ability to
satisfy debt
obligations.

Ability to
manage
expenses to
produce profits
from sales.

ACTIVITY RATIOS
Turnover ratios reflect the number of times assets flow into and out of the
company during the period.
A turnover is a gauge of the efficiency of putting assets to work.
Ratios:

Inventory turnover =

How many times inventory is

created and sold during the
period.
How many times accounts
receivable are created and
collected during the period.
The extent to which total
assets create revenues during
the period.
The efficiency of putting
working capital to work

We will
use this
information
to calculate
the activity ratios
for Norton.

ACCOUNTS RECEIVABLE TURNOVER

Average, net accounts
receivable

Net, credit sales

Accounts
Receivable
Turnover
Accounts
Receivable
Turnover

Sales on Account
Average Accounts Receivable

P494,000
(P17,000 + P20,000) 2

This ratio measures how many times a

company converts its receivables into cash
each year.

= 26.70 times

INVENTORY TURNOVER
Inventory
Turnover

Inventory
Turnover

Cost of Goods Sold

Average Inventory

P140,000
(P10,000 + P12,000) 2

Measures the number of times

inventory is sold and
replaced during the year.

= 12.73 times

OPERATING CYCLE COMPONENTS

The operating cycle is the length of time from when a company makes an
investment in goods and services to the time it collects cash from its accounts
receivable.
The net operating cycle is the length of time from when a company makes an
investment in goods and services, considering the company makes some of its
purchases on credit, to the time it collects cash from its accounts receivable.
The length of the operating cycle and net operating cycle provides information
on the companys need for liquidity: The longer the operating cycle, the greater
the need for liquidity.
Number of Days of Inventory

Number of Days of Receivables

Buy Inventory on
Credit

Pay Accounts
Payable

Sell Inventory on
Credit

Collect Accounts
Receivable

Number of Days of Payables

Net Operating Cycle

Operating Cycle
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OPERATING CYCLE FORMULAS

Time from investment in

inventory to collection
of accounts.
Time from investment in
inventory to collection
of accounts,
considering the useof
use of
trade credit in
purchases.

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OPERATING CYCLE FORMULAS

Average time it
takes to create
and sell
inventory.
Average time it
takes to collect
on accounts
receivable.
Average time it
takes to pay
suppliers.

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EXAMPLE: ACCOUNTS RECEIVABLE

TURNOVER
Average, net accounts
receivable

Net, credit sales

Accounts
Receivable
Turnover
Accounts
Receivable
Turnover

Sales on Account
Average Accounts Receivable

P494,000
(P17,000 + P20,000) 2

This ratio measures how many times a

company converts its receivables into cash
each year.

= 26.70 times

EXAMPLE: NUMBER OF DAYS SALES

IN ACCOUNTS RECEIVABLE
Days Sales
in Accounts
Receivables
Days Sales
in Accounts
Receivables

365 Days
Accounts Receivable Turnover

365 Days
26.70 Times

Measures, on average, how many days it takes

to collect an account receivable.

= 13.67 days

LIQUIDITY RATIO
Liquidity is the ability to satisfy the companys short-term obligations using
assets that can be most readily converted into cash.
Liquidity ratios:
Ability to satisfy current
liabilities using current assets.
Ability to satisfy current
liabilities using the most liquid
of current assets.
Ability to satisfy current
liabilities using only cash and
cash equivalents.

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CURRENT RATIO
Current
Ratio

Current
Ratio

Current Assets
Current Liabilities
P65,000
P42,000

Measures the ability

of the company to pay current
debts as they become due.

1.55 : 1

ACID-TEST (QUICK) RATIO

Acid-Test
Ratio
Acid-Test
Ratio

Current Asset + Account Receivable

Current Liabilities

P50,000
P42,000

1.19 : 1

LEVERAGE ANALYSIS
A companys business risk is determined,
in large part, from the companys line of
business.
Financial risk is the risk resulting from a
companys choice of how to finance the
business using debt or equity.
We use leverage ratios to assess a
companys financial risk.
There are two types of leverage ratios:
component percentages and coverage
ratios.
- Component percentages involve
comparing the elements in the capital
structure.
- Coverage ratios measure the ability to
meet interest and other fixed financing
costs.

Risk

Business
Risk

Financial
Risk

Sales Risk

Operating
Risk

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LEVERAGE RATIOS
Co
mpo
nent
Perc
enta
ge
Solv
ency
Rati
os

Proportion of assets financed with debt.

Cov
erag
e
Rati
os

Ability to satisfy interest obligations.

Proportion of assets financed with longterm debt.

Debt financing relative to equity
financing.
Reliance on debt financing.

Ability to satisfy interest and lease

obligations.
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Ability to satisfy interest obligations with

PROFITABILITY RATIO
Margins and return ratios provide information on the profitability of a company
and the efficiency of the company.
A margin is a portion of revenues that is a profit.
A return is a comparison of a profit with the investment necessary to generate
the profit.

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PROFITABILITY RATIOS: MARGINS

Each margin ratio compares a measure of income with total revenues:

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PROFITABILITY RATIOS: RETURNS

Return ratios compare a measure of profit with the investment that

produces the profit:

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 DuPont Analysis
The Dupont analysis also called the Dupont model is a financial ratio based on
the return on equity ratio that is used to analyze a company's ability to increase
its return on equity. In other words, this model breaks down the return on equity
ratio to explain how companies can increase their return for investors.
The Dupont analysis looks at three main components of the ROE ratio.
Profit Margin
Total Asset Turnover
Financial Leverage
Based on these three performances measures the model concludes that a
company can raise its ROE by maintaining a high profit margin, increasing
asset turnover, or leveraging assets more effectively.
The Dupont Corporation developed this analysis in the 1920s. The name has
stuck with it ever since.
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27

 Formula
The Dupont Model equates ROE to profit margin, asset turnover, and financial
leverage. The basic formula looks like this.
Since each one of these factors is a calculation in and of itself, a more
explanatory formula for this analysis looks like this.
Every one of these accounts can easily be found on the financial statements.
Net income and sales appear on the income statement, while total assets and
total equity appear on the balance sheet.

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 Analysis
This model was developed to analyze ROE and the effects different business
performance measures have on this ratio. So investors are not looking for large
or small output numbers from this model. Instead, they are looking to analyze
what is causing the current ROE. For instance, if investors are unsatisfied with
a low ROE, the management can use this formula to pinpoint the problem area
whether it is a lower profit margin, asset turnover, or poor financial leveraging.
Once the problem area is found, management can attempt to correct it or
address it with shareholders. Some normal operations lower ROE naturally and
are not a reason for investors to be alarmed. For instance, accelerated
depreciation artificially lowers ROE in the beginning periods. This paper entry
can be pointed out with the Dupont analysis and shouldn't sway an investor's
opinion of the company.

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 Example
Let's take a look at Sally's Retailers and Joe's Retailers. Both of these
companies operate in the same apparel industry and have the same return on
equity ratio of 45 percent. This model can be used to show the strengths and
weaknesses of each company. Each company has the following ratios:
Ratio

Sally

Profit Margin

30%

Joe
15%

Total Asset Turnover

0.5

6.0

Financial Leverage

3.0

0.5

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 As you can see, both companies have the same overall ROE, but the
companies' operations are completely different.
Sally's is generating sales while maintaining a lower cost of goods as
evidenced by its higher profit margin. Sally's is having a difficult time turning
over large amounts of sales.
Joe's business, on the other hand, is selling products at a smaller margin, but it
is turning over a lot of products. You can see this from its low profit margin and
extremely high asset turnover.
This model helps investors compare similar companies like these with similar
ratios. Investors can then apply perceived risks with each company's business
model.

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OTHER RATIOS
Earnings per share is net income, restated on a per share basis:

Basic earnings per share is net income after preferred dividends, divided by
the average number of common shares outstanding.
Diluted earnings per share is net income minus preferred dividends, divided
by the number of shares outstanding considering all dilutive securities.
Book value per share is book value of equity divided by number of shares.
Price-to-earnings ratio (PE or P/E) is the ratio of the price per share of equity
to the earnings per share.
- If earnings are the last four quarters, it is the trailing P/E.

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OTHER RATIOS
Measures of Dividend Payment:

Plowback ratio = 1 Dividend payout ratio

- The proportion of earnings retained by the company.

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EXAMPLE: SHAREHOLDER RATIOS

Calculate the book value per share, P/E, dividends per share,
dividend payout, and plowback ratio based on the following
financial information:
Book value of equity

P100 million

Market value of equity

P500 million

Net income

P30 million

Dividends

P12 million

Number of shares

100 million

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EXAMPLE: SHAREHOLDER RATIOS

Book value per share

P1.0 There is P1 of equity, per the

0 books, for every share of stock.

P/E

16.6 The market price of the stock is

7 16.67 times earnings per share.

Dividends per share

P0.1 The dividends paid per share of

2 stock.

Dividend payout ratio

40% The proportion of earnings paid

out in the form of dividends.

Plowback ratio

60% The proportion of earnings

retained by the company.

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EFFECTIVE USE OF RATIO ANALYSIS

In addition to ratios, an analyst should describe the company (e.g., line of
business, major products, major suppliers), industry information, and major
factors or influences.
Effective use of ratios requires looking at ratios
- Over time.
- Compared with other companies in the same line of business.
- In the context of major events in the company (for example, mergers or
divestitures), accounting changes, and changes in the companys product
mix.

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4. PRO FORMA ANALYSIS

Estimate
typical
relation
between
revenues
and salesdriven
accounts.

Estimate
fixed
burdens,
such as
interest and
taxes.

Forecast
revenues.

Estimate
sales-driven
accounts
based on
forecasted
revenues.

Estimate
fixed
burdens.

Construct
future period
income
statement
and balance
sheet.

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PRO FORMA INCOME STATEMENT

Imaginaire Company Income Statement (in millions)
One Year
Ahead
Year 0
Sales revenues
P1,000.0
P1,050.0 Growth at 5%
Cost of goods sold
Gross profit
SG&A
Operating income
Interest expense
Earnings before taxes
Taxes
Net income
Dividends

600.0
P400.0
100.0
P300.0
32.0
P268.0
93.8
P174.2
P87.1

630.0 60% of revenues

P420.0 Revenues less COGS
105.0 10% of revenues
P315.0 Gross profit less operating exp.
33.6 8% of long-term debt
P281.4 Operating income less interest exp.
98.5 35% of earnings before taxes
P182.9 Earnings before taxes less taxes
P91.5 Dividend payout ratio of 50%

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PRO FORMA BALANCE SHEET

Imaginaire Company Balance Sheet, End of Year (in millions)
One Year
Year 0
Ahead
Current assets
P600.0
P630.0 60% of revenues
Net plant and equipment
Total assets
Current liabilities
Long-term debt
Common stock and paid-in
capital
Treasury stock
Retained earnings
Total liabilities and equity

1,000.0
P1,600.0
P250.0
400.0
25.0

1,050.0 100% of revenues

P1,680.0
P262.5 25% of revenues
420.0 Debt increased by P20
million to maintain the same
capital structure
25.0 Assume no change
(44.0) Repurchased shares

925.0
P1,600.0

1,016.5 Retained earnings in Year 0,

plus net income, less
dividends
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P1,680.0

5. SUMMARY
Financial ratio analysis and common-size analysis help gauge the financial
performance and condition of a company through an examination of
relationships among these many financial items.
A thorough financial analysis of a company requires examining its efficiency in
putting its assets to work, its liquidity position, its solvency, and its profitability.
We can use the tools of common-size analysis and financial ratio analysis,
including the DuPont model, to help understand where a company has been.
We then use relationships among financial statement accounts in pro forma
analysis, forecasting the companys income statements and balance sheets for
future periods, to see how the companys performance is likely to evolve.

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