Lesson notes Lesson 10 Understanding and Using Financial Statements Learning objectives Describe the need and supply for financial statement analysis. Learn basic financial statement analytical procedures. Perform horizontal and vertical analysis on financial statement accounts and interpret the data obtained. Calculate a number of ratios related to efficiency, solvency, liquidity, and profitability and explain the information supplied by each, individually and collectively. Aware of the limitations of financial statement analysis Teaching hours Students major in accounting: 3 hours Other students: 6 hours Teaching contents The financial condition and the results of operation of business enterprise are of interest to many groups , including owners, managers, creditors, governmental agencies, employees, and prospective owners and creditors. The principal financial statements, together with supplementary statements and schedules, present much of the basic information needed to make sound economic decisions regarding business enterprises. In this lesson, the various ways in which financial statement data can be analyzed to assist in making these decisions will be discussed. Demand and supply of financial analysis Demand of financial analysis Parties demanding financial statement information include: Shareholders, investors and security analysts; Managers; Employees; Lenders and other suppliers; Customers; and Government regulatory agencies These parties can also be grouped into internal versus external users. Internal users consist of managers and employees while external users consist of the rest in the above list. Suppliers of Financial Statements analysis Business firms are the suppliers of the financial statements information. Limited liability companies are required by the company act to prepare financial statements and disclose the audited financial statements to the public/shareholders. Listed companies are required by the regulations governing the operation of the stock market to disclose audited financial statement information. At the same time, some firms’ internal analysts provide financial statement analysis to help managers make decision. Outside intermediaries agencies, such as financial analysts, bond rating agencies, provide professional services to the external users of financial statement information. Basic analytical procedures The analytical measures obtained from financial statements are usefully expressed as ratios or percentages. Analytical procedure may be used to compare the amount of specific items on a current statement with the corresponding amounts on earlier statements. Analytical procedures are also widely used to show the relationship of individual items to each other and of individual items to totals on a single statement. Techniques of Financial Statement Analysis Vertical analysis and horizontal analysis Vertical (or common size) analysis uses one item on each financial statement as a base amount and expresses other amounts as a percentage of the base. On the balance sheet, total assets are usually the base, while the income statement uses net sales. Financial statements based on vertical analysis allow for easy analysis between companies?or between?time periods of a?company. Formatting financial statements in this way reduces the bias that can?occur when analyzing?companies of?differing?sizes.?It also allows for the analysis of a company over various time periods, revealing, for example, what percentage of sales is cost of goods sold and how?that value has changed over time. Horizontal (or trend) analysis uses data from prior years as a yardstick. Usually, the oldest year is used as a base, line by line, and subsequent years are expressed as a percentage of the base. In essence, the analyst is looking for areas of deterioration or improvement from a prior period. Care must be taken with horizontal analysis because small changes in large items (such as inventory or capital assets) are sometimes far more significant than large changes in small accounts (such as prepaids), which can be volatile. Horizontal analysis on an income statement indicates sales trends and the behaviour of the various expense components over time. The trends in these percentages may reveal significant insights into the strategy and efficiency of the operation. The profit margin on sales percentage (a ratio in its own right) is especially important due to the size of the cost of goods sold expense category and its vulnerability to operating inefficiencies and competitive forces. A slippage of?1%?or?2%, or even 0.1%, in gross profit can make a large difference to returns earned. Ratio analysis Financial ratio analysis is the calculation and comparison of ratios which are derived from the information in a company's financial statements. Ratio analysis is very useful for users of financial statement information, for example: They facilitate inter-company comparison; They downplay the impact of size and allow evaluation over time or across entities without undue concern for the effects of size difference; They serve as benchmarks for targets such as financing ratios and debt burden; They help provide an informed basis for making investment-related decisions by comparing an entity’s financial performance to another. This lesson classifies ratios into five analytical groups, which are: Profitability analysis ratios, which show how successful a company is in terms of generating returns or profits on the Investment that it has made in the business. If a business is Liquid and Efficient it should also be Profitable. Main profitability analysis ratios: Return on Sales or Profit Margin (%): The Profit Margin of a company determines its ability to withstand competition and adverse conditions like rising costs, falling prices or declining sales in the future. The ratio measures the percentage of profits earned per dollar of sales and thus is a measure of efficiency of the company. The formula: Return on Sales or Profit Margin = (Net Profit / Net Sales) x 100 Return on Assets: The Return on Assets of a company determines its ability to utilize the Assets employed in the company efficiently and effectively to earn a good return. The ratio measures the percentage of profits earned per dollar of Asset and thus is a measure of efficiency of the company in generating profits on its Assets. The formula: Return on Assets = (Net Profit / Total Assets) x 100 Return on Equity or Net Worth: The Return on Equity of a company measures the ability of the management of the company to generate adequate returns for the capital invested by the owners of a company. Generally a return of 10% would be desirable to provide dividends to owners and have funds for future growth of the company The formula: Return on Equity or Net Worth = (Net Profit / Net Worth or Owners Equity) x 100 Net Worth or Owners Equity = Total Assets (minus) Total Liability Activity analysis (efficiency analysis) ratios, which are ratios that come off the the Balance Sheet and the Income Statement and therefore incorporate one dynamic statement, the income statement and one static statement , the balance sheet. These ratios are important in measuring the efficiency of a company in either turning their inventory, sales, assets, accounts receivables or payables. It also ties into the ability of a company to meet both its short term and long term obligations. Main activity analysis ratios and the formula: DSO (Days Sales Outstanding): The Days Sales Outstanding ratio shows both the average time it takes to turn the receivables into cash and the age, in terms of days, of a company's accounts receivable. The ratio is regarded as a test of Efficiency for a company. The effectiveness with which it converts its receivables into cash. This ratio is of particular importance to credit and collection associates. The formula: Regular DSO = (Total Accounts Receivables/Total Credit Sales) x Number of Days in the period that is being analyzed Inventory Turnover ratio: This ratio is obtained by dividing the 'Total Sales' of a company by its 'Total Inventory'. The ratio is regarded as a test of Efficiency and indicates the rapidity with which the company is able to move its merchandise. The formula: Inventory Turnover Ratio = Net Sales / Inventory It could also be calculated as: Inventory Turnover Ratio = Cost of Goods Sold / Inventory Accounts Payable to Sales (%): This ratio is obtained by dividing the 'Accounts Payables' of a company by its 'Annual Net Sales'. This ratio gives you an indication as to how much of their suppliers money does this company use in order to fund its Sales. Higher the ratio means that the company is using its suppliers as a source of cheap financing. The working capital of such companies could be funded by their suppliers. The formula: Accounts Payables to Sales Ratio = [Accounts Payables / Net Sales ] x 100 Liquidity analysis ratios, which help analyze a company's ability to generate cash or other highly liquid assets in order to extinguish debt or allocate resources. These ratios are important in measuring the ability of a company to meet both its short term and long term obligations. Main liquidity ratios and the formula: Current Ratio: This ratio is obtained by dividing the 'Total Current Assets' of a company by its 'Total Current Liabilities'. The ratio is regarded as a test of liquidity for a company. It expresses the 'working capital' relationship of current assets available to meet the company's current obligations. The formula: Current Ratio = Total Current Assets/ Total Current Liabilities Quick Ratio: This ratio is obtained by dividing the 'Total Quick Assets' of a company by its 'Total Current Liabilities'. Sometimes a company could be carrying heavy inventory as part of its current assets, which might be obsolete or slow moving. Thus eliminating inventory from current assets and then doing the liquidity test is measured by this ratio. The ratio is regarded as an acid test of liquidity for a company. It expresses the true 'working capital' relationship of its cash, accounts receivables, prepaids and notes receivables available to meet the company's current obligations. The formula: Quick Ratio = Total Quick Assets/ Total Current Liabilities Quick Assets = Total Current Assets (minus) Inventory Long-term debt-paying ability analysis ratios, which measure the degree of protection of suppliers of long-term funds and can also aid in judging a firm’s ability to raise additional debt and its capacity to pay its liabilities on time. Main activity analysis ratios and the formula: Total Debts to Assets: Provides information about the company’s ability to absorb asset reductions arising from losses without jeopardizing the interest of creditors The formula: Total debts to assets = Total Assets/ Total Liabilities Debt to Equity:Indicates how well creditors are protected in case of the company’s insolvency. The formula: Debt to equity = Total debt/ Total equity Interest Coverage Ratio (Times Interest Earned):Indicates a company’s capacity to meet interest payments. Uses EBIT (Earnings Before Income and Taxes). The formula: Interest Coverage Ratio=EBIT/Interest Expense Market Strength ratios, whose calculation is based on market price. Market price provides information about how investors view the potential return and risk connected with owning the company's stock. But market price by itself is not very informative. Market price must be related to earnings by considering the price/earnings ratio and the dividends yield. Price/Earnings ratio, which is the ratio of market price per share to earnings per share and useful for comparing the value placed on a company’s shares in relation to the overall market. Dividends yield, which measures a stock’s current return to an investor in the form of dividends. A comprehensive analysis: Dupond Analysis Return on equity (ROE) is one of the most important indicators of a firm’s profitability and potential growth. Companies that boast a high return on equity with little or no debt are able to grow without large capital expenditures, allowing the owners of the business to withdrawal cash and reinvest it elsewhere. Many investors fail to realize, however, that two companies can have the same return on equity, yet one can be a much better business There are three components in the calculation of return on equity using the traditional DuPont model; the net profit margin, asset turnover, and the equity multiplier. By examining each input individually, we can discover the sources of a company's return on equity and compare it to its competitors. The net profit margin is simply the after-tax profit a company generated for each dollar of revenue. Net profit margins vary across industries, making it important to compare a potential investment against its competitors. The asset turnover ratio is a measure of how effectively a company converts its assets into sales. The asset turnover ratio tends to be inversely related to the net profit margin; i.e., the higher the net profit margin, the lower the asset turnover. The result is that the investor can compare companies using different models (low-profit, high-volume vs. high-profit, low-volume) and determine which one is the more attractive business. It is possible for a company with terrible sales and margins to take on excessive debt and artificially increase its return on equity. The equity multiplier, a measure of financial leverage, allows the investor to see what portion of the return on equity is the result of debt. Calculation of Return on Equity To calculate the return on equity using the DuPont model, simply multiply the three components (net profit margin, asset turnover, and equity multiplier.) Return on Equity = (Net Profit Margin) (Asset Turnover) (Equity Multiplier) Some discussion about financial statement analysis Financial statement analysis can provide meaningful insight into the strategy, management, and operation of a firm. It can also “not provide useful information” by producing an overabundance of data. Before analysis starts, the following questions must be answered: What is the purpose of the analysis? Credit and investment decisions will focus on different areas. What business is the company in? What is going on in the industry and in the economy in general? What is going on in the company right now? Information may be available from the financial press or directly from the company. What strategy does this firm use to compete in the industry? Are there variables important to success that the financial statements do not capture? Are there events reflected in the financial statements — such as changes in accounting principles, changes in strategy, unusual or nonrecurring factors — that should be factored out before ratios are calculated? Is this firm comparable to industry averages, or are there differences in accounting policy, average size, or strategy that will invalidate comparison? At the same time, analysts must be aware that the above techniques are not absolute measures of performance. They work best when they are used to confirm or refute other information. When using analytical tools to evaluate a company, the analyst should keep in mind the limitations of analysis, for example: Not all information about a company is reported in the financial statements. For example, the effect of a change in the future market price of the firm’s product, future technological change, the strength of marketing or production staff, the effect of government action, and union activities are not likely to be reflected in the numbers. The analyst must obtain information about such factors from other sources, such as the financial press. Ratios and other measurements are based on past performance, reported on the historical cost basis. If the current value of a firm’s assets is significantly different from historical costs, or if intangible assets are significant, ratio analysis may not yield a fair assessment of the company’s performance or condition. Even within the same industry, different companies may use different accounting policies. For example, inventory valuation may be based on LIFO, FIFO, or average cost, and amortization may be calculated using the straight-line method or an accelerated method. The analyst should read the notes to the financial statements to determine a company’s accounting policies and then adjust for any differences in accounting policy before attempting to compare results with other firms in the same industry. The past may not predict the future. Although ratio analysis suffers from the limitations of accounting information, a careful and sensible analyst should be able to obtain a clear picture of the company’s operations and provide useful information to investors and creditors. Summary Users of financial statements often gain a clearer picture of the economic condition of an entity by the analysis of accounting information. The analytical measures obtained from financial statements are usually expressed as ratios or percentages. Financial analysis techniques work best when they are used to confirm or refute other information. When using analytical tools to evaluate a company, the analyst should keep in mind the limitations of analysis. Key points Ratio analysis of financial information. Limitations of financial statement analysis. Reading material Philip E. Fess and Carl S. Warren, Accounting Principles, South-Western Publishing Co., 1987. Beechy, Thomas H., and Conrod, Joan E.D., Intermediate Accounting, McGraw-Hill, Ryerson Limited, 2003. Wall Street Research Network: http://www.wsrn.com. Report Gallery annual reports: http://www.reportgallery.com