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Financial Statement

Analysis

Dr. Hermanto, MBA

Fakultas Ekonomi

Universitas Mataram

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Financial Accounting and

Business

Karl Marx: Business cannot exist, except invery primitive forms, without accounting.

Accounting data makes the business visible,and makes it possible to manage thebusiness and understand it.

Accounting makes it possible for the

business to work in many locations,directed by a central team.

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Uses of Financial Statement

IASC:

The objective of financial statement is toprovide information about the financialposition, performance and changes infinancial position of an enterprise that isuseful to a wide range of users in making

economic decisions.

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Annual Report

Typically consists of:

Income statement

The balance sheet The notes to the accounts

The cash flow statement

The audit report

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Financial Statements

The balance sheet does not, though,purport to show what the company isworth.

Financial statements give certaineconomic information about a companys

past activities.

Financial statements give partialinformation. Hermanto

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Important to know in usingfinancial statements:

a) What are the rules

b) To what extent are they flexible

c) How this impacts upon intepretation of

the information

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The Company Value

From a market perspective:

a) Based on future earnings

b) These earnings may well be different indifferent situations.

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Business Survival:

There are two key factors for business survival: Profitability

Solvency

Profitability is important if the business is togenerate revenue (income) in excess of theexpenses incurred in operating that business.

The solvency of a business is importantbecause it looks at the ability of the business inmeeting its financial obligations.

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Financial Statement Analysis

Financial Statement Analysis will help businessowners and other interested people to analysethe data in financial statements to provide them

with better information about such key factors fordecision making and ultimate business survival.

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Purpose: To use financial statements to evaluate an

organisations Financial performance

Financial position.

To have a means of comparative analysis across timein terms of: Intracompany basis (within the company itself)

Intercompany basis (between companies)

Industry Averages (against that particularindustrys averages) To apply analytical tools and techniques to financial

statements to obtain useful information to aid decisionmaking.

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Financial statement analysis involves analysing theinformation provided in the financial statements to: Provide information about the organisations:

Past performance

Present condition Future performance

Assess the organisations:

Earnings in terms of power, persistence, qualityand growth

Solvency

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Effective Financial Statement Analysis

To perform an effective financial statementanalysis, you need to be aware of theorganisations:

business strategy

objectives

annual report and other documents like articles aboutthe organisation in newspapers and business reviews.

These are called individual organisational factors.

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Effective Financial Statement Analysis

Requires that you:

Understand the nature of the industry in whichthe organisation works. This is an industryfactor.

Understand that the overall state of theeconomy may also have an impact on theperformance of the organisation.

Financial statement analysis is more than justcrunching numbers; it involves obtaining abroader picture of the organisation in order toevaluate appropriately how that organisation is

performing

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Tools of Financial Statement Analysis:

The commonly used tools for financial statementanalysis are:

Financial Ratio Analysis

Comparative financial statements analysis: Horizontal analysis/Trend analysis

Vertical analysis/Common size analysis/ ComponentPercentages

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Financial Ratio Analysis

Financial ratio analysis involves calculating and analysingratios that use data from one, two or more financialstatements.

Ratio analysis also expresses relationships betweendifferent financial statements.

Financial Ratios can be classified into 5 main categories: Profitability Ratios

Liquidity or Short-Term Solvency ratios

Asset Management or Activity Ratios

Financial Structure or Capitalisation Ratios Market Test Ratios

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Profitability Ratios

3 elements of the profitability analysis:

Analysing on sales and trading margin

focus on gross profit

Analysing on the control of expenses

focus on net profit

Assessing the return on assets and returnon equity

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Profitability Ratios

Gross Profit % = Gross Profit * 100Net Sales

Net Profit % = Net Profit after tax * 100

Net Sales

Or in some cases, firms use the net profit before tax figure. Firms

have no control over tax expense as they would have over otherexpenses. Net Profit % = Net Profit before tax *100

Net Sales

Return on Assets = Net Profit * 100

Average Total Assets

Return on Equity = Net Profit *100

Average Total Equity

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Short-term funds management Working capital management is important as it signals the firms ability

to meet short term debt obligations.

For example: Current ratio

The ideal benchmark for the current ratio is $2:$1 where there are twodollars of current assets (CA) to cover $1 of current liabilities (CL). Theacceptable benchmark is $1: $1 but a ratio below $1CA:$1CLrepresents liquidity riskiness as there is insufficient current assets to

cover $1 of current liabilities.

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Working Capital = Current assets Current Liabilities

Current Ratio = Current Assets

Current Liabilities

Quick Ratio = Current Assets Inventory PrepaymentsCurrent Liabilities Bank Overdraft

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Efficiency of asset usage How well assets are used to generate revenues

(income) will impact on the overall profitability of thebusiness.

For example: Asset Turnover

This ratio represents the efficiency of assetusage to generate sales revenue

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Asset Turnover = Net Sales

Average Total Assets

Inventory Turnover = Cost of Goods SoldAverage Ending Inventory

Average Collection Period = Average accounts ReceivableAverage daily net credit sales*

* Average daily net credit sales = net credit sales / 365

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Financial Structure or Capitalisation Ratios

Long term funds management Measures the riskiness of business in terms of debt

gearing.

For example: Debt/Equity

This ratio measures the relationship between debt andequity. A ratio of 1 indicates that debt and equity fundingare equal (i.e. there is $1 of debt to $1 of equity) whereasa ratio of 1.5 indicates that there is higher debt gearing inthe business (i.e. there is $1.5 of debt to $1 of equity). Thishigher debt gearing is usually interpreted as bringing in

more financial risk for the business particularly if thebusiness has profitability or cash flow problems.

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Financial Structure or Capitalisation Ratios

Debt/Equity ratio = Debt / Equity

Debt/Total Assets ratio = Debt *100

Total Assets

Equity ratio = Equity *100

Total Assets

Times Interest Earned = Earnings before Interest and Tax

Interest

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Market Test Ratios

Based on the share market's perception of thecompany.

For example: Price/Earnings ratio

The higher the ratio, the higher the perceived

quality of the earnings by the share market.

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Market Test Ratios

Earnings per share = Net Profit after taxNumber of issued ordinary shares

Dividends per share = Dividends

Number of issued ordinary shares

Dividend payout ratio = Dividends per share *100

Earnings per share

Price Earnings ratio = Market price per share

Earnings per share

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Horizontal analysis/Trend analysis

Trend percentage Line-by-line item analysis

Items are expressed as a percentage of a

base year This is a time series analysis

For example, a line item could look at

increase in sales turnover over a period of5 years to identify what the growth in salesis over this period.

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Vertical analysis/Common size analysis/Component Percentages

All items are expressed as a percentage of acommon base item within a financial statement

e.g. Financial Performance sales is the base

e.g. Financial Position total assets is the base Important analysis for comparative purposes

Over time and

For different sized enterprises

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Limitations of Financial Statement Analysis

We must be careful with financial statementanalysis.

Strong financial statement analysis does notnecessarily mean that the organisation has a strong

financial future. Financial statement analysis might look good but there

may be other factors that can cause an organisation tocollapse.

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Illustration: Financial statement analysis

The following financial statements of Walker Ltdwere prepared in accordance with New ZealandGAAPs. Walker Ltd is a diversified enterprisewith its main interests in the manufacture and

retail of plastic products. The financial statements of Walker Ltd need to be

analysed. An investor is considering purchasingshares in the company. Relevant ratios need to

be selected and calculated and a report needs tobe written for the investor. The report shouldevaluate the companys performance andposition

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Walker Ltd

Statement of Financial Position as at 31 March2005 2006 Horizontal

Analysis

$000 $000 $000 $000Current Assets

Bank 33.5 41.0

Accounts receivable 240.8 210.2

Inventory 300.0 370.8

574.3 622.0 108

Non-current assets

Fixtures & fittings (net) 64.6 63.2

Land & buildings (net) 381.2 376.2445.8 439.4 99

Total assets 1,020.1 1,061.4 104

Current Liabilities

Accounts payable 261.6 288.8

Income tax 60.2 76.0

321.8 364.8 113

Non-current liabilities

Loan 200.0 60.0 30

Shareholders Funds

Paid-up ordinary capital 300.0 334.1

Retained profit 198.3 302.5

498.3 636.6 128

Total liabilities & equity 1,020.1 1,061.4 104

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Walker Ltd

Statement of Financial Performance for year ended 31 March

2005 2006 Horizontal

Analysis$000 $000 $000 $000

Sales 2,240.8 2,681.2 120

Less Cost of goods sold 1,745.4 2,072.0 119

Gross profit 495.4 609.2 123

Wages & salaries 185.8 275.6

Rates 12.2 12.4

Heat & light 8.4 13.6Insurance 4.6 7.0

Interest expense 24.0 6.2

Postage & telephone 9.0 16.4

Depreciation -

Buildings 5.0 5.0

Fixtures & fittings 27.0 276.0 32.8 369.0 134

Net profit before tax 219.4 240.2 109

Less Income tax 60.2 76.0 126

Net profit after tax 159.2 164.2 103

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Walker Ltd

Statement of Cash Flows for the year ended 31 March

2005 2006

$000 $000 $000 $000Cash flow from operations

Receipts from customers 2,281 2,711.8

Payments to suppliers & employees (2,050) (2,460.4)

Interest paid (24) (6.2)

Tax paid (46.4) (60.2)

Net cash flow from operating activities 160.6 185Investing activities

Purchase of non-current assets (121.2) (31.4)

Net cash used in investing activities (121.2) (31.4)

Financing activities

Dividends paid (32.0) (40.2)

Issue of ordinary shares 20.0 34.1Repayment of loan capital -__ (140.0)

Net cash outflow from financing activities (12) (146.1)

Increase in cash & cash equivalents 27.4 7.5

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Additional information:

Credit purchases for the year 2006 were $2,142,800.

General prospects for the major industries in whichWalker is involved look good with a forecast glut of oil setto reduce the cost of production and world demand forplastic remaining strong.

Benchmarks:

There are no exact benchmarks for Walker Ltd because itis a diversified company. The following are averageindicators that relate to the plastic retailing andmanufacturing industries for the year 2006. Gross profit margin 25%

Net profit margin 7% Inventory turnover 6 times Debt/equity ratio 0.6 : 1 Return on Assets 12% Return on Equity 20%

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Relevant ratios

Profitability

ratios:

Benchmarks 2005 2006

Gross ProfitMargin

Industry

25%

22% 22.7%

Net ProfitMargin

Industry

7%

7.1% 6.1%

Return on

Assets

12% 15.6% 15.5%

Return onEquity

Industry

20%

32% 26%

Important note: The calculations of the ratios in this illustration did not use averages for total assets, equity and

inventory. The 2005 and 2006 year end figures were used and this is a slight variation to the formulas provided.

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Asset

Management

ratios:


Inventory

Turnover

Industry

6 %

5.8 times 5.58 times

Asset Turnover Not given 2.2 2.53

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Liquidity

ratios:


Current Ratio Ideal standard

2:1

Acceptablestandard

1:1

1.78:1 1.70:1

Quick Ratio Ideal standard

2:1

Acceptablestandard

1:1

0.85:1 0.69:1

Days Payable Standard

30 days

Creditpurchases not

available

49.19 days

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Financial

Structureratios:


Debt/Equity Industry

0.6:1

Standardbenchmark

1:1

1.05: 1 0.67:1

TIE Standardbenchmark:

Between 3 and 5.

Below 3 risky.Above 5 very

favourable

10.14 times 39.74 times

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Report

For the investor considering the purchase of shares in

the company, the return they will earn is the key financialfactor but an overall evaluation of the companysperformance and position is also important to get abetter picture of how well the company is actually doing.

ROE in 2006 is 26%. Whether or not this is attractivedepends on the perceived riskiness of this investmentand other alternatives available but this return is certainlymore attractive than current bank interest rates.

ROE has decreased by 4% but the companys ROE at

26% is still better than the industry average of 20% Riskiness of business is being reduced by the significant

repayment of loan in 2006.

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Profitability The NP% and ROA ratios show a small downward

trend in % over the 2 year period. ROE% ratio show amore significant decrease but is still better than theindustry average.

Gross Profit Margin is slightly unfavourable at about2.3% below the industry benchmark of 25%.

The horizontal analysis information show that Saleshave increased by 20%. However operating costshave increased by 34%.

Asset Management

IT has gone down slightly from 5.8 to 5.58 times. IT is still close to the industry benchmark of 6 times.

AT has increased showing more sales beinggenerated from asset usage

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Liquidity

Current ratios of 1.78:1 (2005) and 1.70: 1 are atabove acceptable levels but below ideal level.

Quick ratios appear more of a concern being belowacceptable levels in both years and even more so in2006 (0.69:1).

Raises some concerns over the liquidity of thebusiness and inventory management (although ITratio only shows a slight decline in 2006).

Days Payable is a concern as there may be poor debtpayment management.

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Financial Structure Although slightly higher than D/E industry benchmark

(0.67:1), business has become less risky due to thesignificant repayment of loan in 2006. TIE is extremely good for the business at 39.74 times

(well above 5 the standard benchmark).

Cash flow situation

Strong cash flow from operating activities (increasedfrom 160,600 to 185,000).

Spending under investing activities suggest moregrowth.

Repayment of debt under financing activities imply

restructuring of business to have more equity fundingrather than debt funding.

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Given:

1) the strong forecast for the industry (ie generalprospects looking good and world demand forplastic products remaining strong),

2) the sales growth in this business,

3) acceptable ratios as they are quite close to theindustry averages,4) good cash flows from operating activities and5) favourable ROE, although it has decreased, it

is still better than the industry average ROE.

=> it is recommended that the investor purchase sharesin the Walker Ltd company.

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