intermediate financial statement analysis: ratios, … financial statement analysis: ratios, trends,...

Intermediate Financial Statement Analysis: Ratios, Trends, & Comparisons Instructor: Linda Keith NASBA Field of Study: Accounting CPE Credits: 2 Recording Date: April 2010

1 © Linda Keith CPA Inc 2010 | www.LindaKeithCPA.com

Intermediate Financial Statement Analysis Ratios, Trends and Comparisons Linda Keith CPA CSP works with banks and credit unions to develop

consistent, clear guidelines and tools for loans to businesses and their owners. She then trains the lenders in credit analysis to help them make good loans and make more of them. Linda brings the same clear and practical information to business owners and to their advisors.

She is experienced in public accounting, business consulting and corporate training, is a real estate investor and was the CFO of a construction company. In 1976, the Washington State Auditor‟s Office hired Linda as an Examiner, the second woman ever to hold that position. In 1994, the Central Bank of Russia invited her to present to them on business lending.

Her understanding of financial analysis, business and lending is not theory. It is all practical, real-world information.

Linda is Certified2. As a Certified Public Accountant and a Certified Speaking Professional, she understands it and she can explain it!

Linda Keith CPA Inc PO Box 1366 Olympia, WA 98507 360 455 1569 www.LindaKeithCPA.com

See index at 0 for quick look-up of ratios and percentages.

Intermediate Financial Statement Analysis: Ratios, Trends and Comparisons


Analysis Overview

Shareholders base their investment decisions, lenders their credit decision and managers their management decisions on their estimate of the solvency and profitability of the business. Solvency analysis considers a business‟s ability to meet its financial obligations as they become due. Profitability analysis considers a business‟s ability to generate profits currently and in the future in order to repay the debt, rather than being forced to liquidate assets or inject capital to do so, and to provide for an adequate return for the owners. You will evaluate the solvency and profitability by looking at more than one period of data (trend analysis) and comparing the company to the industry averages (comparative analysis). In the pages that follow, you will learn how to do horizontal, vertical and ratio analysis. We will use Barb‟s Floral as an example. We will use ProfitCentstm by Sageworks as a source for industry averages. Other sources include Prentice Hall, Dun & Bradstreet and RMA. These sources contain information for hundreds of types and sizes of businesses as well as instructions that explain the use of these and other ratios in analyzing a financial statement.

Limitations of Analysis

Estimates used and choices of accounting methods result in financial statements that are not necessarily the same as if another CPA or company management had prepared them so they are not totally comparable.

Also, industry averages are just that, averages. A florist shop that also sells gifts and antiques will not have the same inventory turnover as one that sells only flowers.

Finally, analysis often raises questions. The user of the statements will have to look elsewhere for the answers. The lender will ask the owner. The owner will ask the accountant. To get the answers may require more detailed accounting information such as aging of receivables.



These financial statements are also the last page of the handout. Rip it off so you can easily follow along with the calculations.



Liquidity

The ability of an entity to meet its current obligations on a timely basis • Working Capital • Current Ratio • Quick Ratio

Working Capital

Working Capital- The available liquidity resources after current obligations are met.

Current Assets- Cash and what we expect to turn into cash in the next 12 months.

Current Liabilities - n. Payables and principal due in the next 12 months.



Current Ratio

The current ratio helps judge what is a comfortable amount of working capital.

How to say it?

“2 point 8 4 to 1”

How to read a ratio:

For every dollar of <whatever is on the bottom> there is <how much> of <whatever is on the top>.

For every dollar of <current liabilities> there is <$2.84> of <current assets>.

For every dollar of <payables due in the next twelve months> there is <$2.84> of <cash and things we think will turn into cash in the next twelve months>.

ProfitCentstm from Sageworks:

Industry Average is 2.5:1

The current year is higher than the industry.

The current year is more liquid than the industry.

Is the current year better than the industry?

Can it be too low?

This could indicate liquidity problems. They may need an infusion of owner capital or borrowed money to get back into a comfort zone.



Consider the size of the company. Many closely held companies with few owners have low liquidity because the owner takes the profits out and stashes it in their personal, and possibly liquid, assets.

Many commercial lenders look at a consolidated financial picture to determine creditworthiness of a small to medium size business.

Can it be too high?

Can a business be too liquid? Well, yes. To the extent that current assets like excess cash are not put into play, the business is missing opportunities for additional profits.

One reason a business might appear to be over-liquid is if it has just raised funds for future expansion.

Quick Ratio

The quick ratio or acid test measures the instant debt paying ability of the company.

Quick assets are the assets you have to cover a sudden emergency; assets you could take to the bank and convert to cash right away if you had to. This leaves out merchandise inventory, for example, because it has yet to be sold.

ProfitCentstm from Sageworks:

Industry Average is 1.3:1

The current year is higher than the industry.

The current year is more liquid than the industry.

Is the current year better than the industry?



Be cautious of General Rules

A current ratio of 2:1 has generally been considered appropriate. This general rule doesn‟t fit all businesses of all sizes in all industries, however.

For example, if a company has a small inventory and easily collectible receivables it can probably operate safely with a lower current ratio.

A quick ratio of 1:1 was the general rule.

Compare these ratios to prior periods and to industry averages. In this case, the general rule is significantly different from the average for a florist shop of this size.

Asset Utilization

Operating Cycle

Generally, the more times in a year the business can go through its cycle the more profitable it can be. The business owner/manager wants to optimize the time goods are held in inventory and the time it takes to collect the receivables.



How short can it be?

For purposes of profitability, it might seem that the very shortest cycle would be the best. However, if the owner keeps inventory too low, he‟ll be out of stock when the customer wants to buy and may lose sales.

If the owner doesn‟t offer as liberal credit terms as his competitor, he may lose market share.

It is a matter of balance.

Inventory Turnover

This helps assess how quickly a company moves its inventory. This figure can be used to compare to the industry and is helpful in comparing the trends within the company.

How it is calculated

Divide Cost of Goods Sold (from the income statement) by Inventory (from the balance sheet). This tells you how many times in a year the inventory is sold completely off.

Of course, in real life they don‟t sell the inventory to zero and then buy up again. The turnover is still helpful for comparisons.

What does it mean?

The greater the inventory turnover figure, the less time inventory sits on the shelf. Since cashflow is tied up in inventory and it costs money to store and insure it, generally the higher the figure the better.

On the other hand, many things affect how much inventory a company should keep on hand.

Flowers and food, because of spoilage, must have a fast turnover and are readily replaced when sold.



A hardware store that competes based on having everything you might need must keep many items stocked that may turn over very slowly.

If the major supplier is overseas, a business would have to keep a higher inventory level than if the supplier is across town.

DAYS IN INVENTORY

This takes the calculation one step further, and often makes more sense to people. Divide 365 days by the inventory turnover and you will find out how many days on average the inventory sits before being sold. As an example, if the inventory turns six times a year, it sits around for about two months...or 60 days.

ProfitCentstm from Sageworks: Industry Average is 35 days

Excessive inventory

Turnover will be slower and days in inventory longer. This lowers liquidity and reduces profit due to holding costs.

Not enough inventory

While the company benefits from having less cash tied up in inventory and lower carrying costs, it may be losing sales since it cannot meet customers‟ needs.

Average inventory

It is more accurate to use an average inventory figure developed from monthly or quarterly financial statements. If you only have annual statements, you can use the year-end inventory.



It may skew your results if the year-end inventory was higher or lower than average for some reason. Keep in mind that it is likely the industry averages were developed using year-end figures.

Receivables Turnover

Indicates how fast the receivables are collected. This can be translated into days in receivables.

If the company‟s credit policy is net 30 and their days in receivables is 45, they are not operating within their credit policy.

An accounts receivable turnover of 12 (times a year) translates to 30 days in receivables. If they collect receivables within 60 days on average, then the accounts receivable turnover is 6 times a year.

Generally, a higher turnover is better...and one that is increasing is a positive trend. The faster the company turns its receivables the less cashflow is tied up in „lending‟ to customers.

If accounts receivable turnover is dropping (which translates to slower collections), consider whether the industry as a whole or the local economy is going through a slowdown.

It also may be that management has relaxed credit policy as a competitive strategy counting on the increased sales from a more liberal policy to offset the slowdown in collections.

Days in receivables

This takes the calculation one step further, and often makes more sense to people. Divide 365 days by the receivables turnover and you will find out how many days on average the receivable sits on the books before being collected.



As an example, if receivables turn six times a year, it takes about two months to collect...or 60 days.

ProfitCentstm from Sageworks: Industry Average is 25 days

Cash versus credit sales

Another factor that will change AR turnover and days in receivables is the composition of sales between cash and credit. The days in receivables on cash sales is zero!

We used net sales rather than credit sales. On a financial statement you cannot determine how much of sales were cash sales compared to credit.

However, days in receivables will drop (and turnover increase) if cash sales increase as a proportion of overall net sales.

If half of the sales were credit sales and these were paid within 30 days, the average days in receivables would only be 15. Industry averages use net sales. Managers use credit sales because they have access to that information and it gives more meaningful results.

Average accounts receivable

As with inventory turnover, average accounts receivable figures will give you a more accurate picture than year-end receivables.

Use the average if you have interim financial statements or average beginning and ending figures for the year if you have a two-year balance sheet.



Operating Cycle Revisited

Prior Year: 72.4 Inventory Days + Receivables Days 41.5 =

Current Year: 65.9 Inventory Days + Receivables Days 39.5 =

Working harder on collecting receivables and getting inventory moving could improve both cashflow and profitability.

Consider if there are good reasons this company is not hitting the industry average. Antiques in a flower shop?

Fixed Asset Turnover

Probably not the most relevant ratio if fixed assets are not significant.



Leverage

The mix of debt and equity; the financial risk associated with debt

Debt to Equity Ratio

This ratio is also called Total Liabilities to Net Worth. It shows the amount of external (borrowed) funds compared to the amount of internal (owner) funds.

Stated another way, it indicates the degree of dependence on creditors rather than owners.

ProfitCentstm from Sageworks: Industry Average is 2.6:1

Creditors like a smaller number because they are taking less risk.

Investors like a larger number because they are getting more leverage.

Too low?

A very low debt-to-equity ratio can indicate a business owner who is too conservative and foregoes good business opportunities because of fear of debt.

Too high?

Several possibilities...perhaps the borrower has been told „yes‟ by lenders a few times too many. Or the owners have been withdrawing capital out of the business.

Before you get too concerned, consider a pattern I often see in the smaller businesses. The company makes money and the owner takes it home...regardless of adequate capitalization of the business.



When you look at the owner‟s financials, you may find there are plenty of liquid assets and the owner may stand ready to reinvest the capital if need be.

With smaller businesses, you often have to look at the big picture.

How much can they borrow?

To calculate the additional debt the company could carry, multiply the acceptable debt to equity ratio (from industry standards or your internal guidelines) times end of year equity (capital).

Compare your answer to the end of year debt (total liabilities) to see if there is room to lend more...and how much.

Better yet, use the most recent financial statement you can obtain. Remember a lot may have happened since the previous year-end.



Debt Coverage Ratio

Lenders are very interested in this number. It is the amount of times they have the debt payments for the year covered by operating cashflow.

EBITDA = Earnings Before Interest, Taxes, Depreciation and Amortization

I think of it as „Operating Cashflow‟

Debt Payments = Current portion of long-term debt plus interest expense

Most lenders require a 1.2:1 Debt Coverage Ratio. This company is above the lender‟s requirements.

This is just one factor. Lenders will consider collateral, type of loan, and the strength of the owner/guarantor. They‟ll also consider if it is the type of loan they want to do more (or less) of.

Profitability

Definition: The ability to control pricing and costs; effectiveness of resource utilization

Common indicators:

Return on assets

Return on equity

Net Profit %

Gross Profit %

Operating Cost %

I am careful about any ratio that uses net profits with a small business. Often the owners take all the profits home.



Return on Assets

Items in gray are related to net income. See the caution above about using net profit or net income based ratios with small businesses.

This ratio helps us see if increased assets are bringing the desired improvement in the bottom line.

Return on Equity

Items in gray are related to net income. See the caution above about using net profit or net income based ratios with small businesses.

This ratio helps us see if the owners are getting a favorable return on their equity. Presumably, they could put the same amount of equity in the stock market, real estate or some other „investment‟.

Realistically, with a small business, the owners bought themselves a job. The return they are getting is partly related to investment and partly related to the benefits of self-employment.



Common Sizing

This is also called VERTICAL ANALYSIS. It makes it easier to see the changes from year to year when the business is growing.

With sales going up, we would expect to see many expenses going up. The question is have they gone up too much?

Vertical analysis sets all expense and profit items against sales. (Sales is 100%...and every other number is divided by the net sales number for that year.)

So, even though sales may be going up, we can see which expenses are going up proportionately.

If any are going up faster than sales, this method will catch our attention and we can wonder (and perhaps ask) why.

Balance Sheet

The same technique can be applied to the ASSET and to the LIABILITIES AND CAPITAL sections of the balance sheet.

Industry comparisons

Vertical analysis allows comparison to industry averages as well as to prior periods of the same company. (Sageworks, RMA, Prentice Hall and D&B give comparative data using vertical analysis).



Cost of Goods Sold %

You can calculate this or just look at the „common size‟ income statement on the previous page to get the information you need.

This may not be reasonable if their product mix or distance from suppliers makes a 44% COGS% unreasonable.



Operating Costs %

Use the common sized income statement to zero in on any cost that is increasing as a % of sales. If net income is a helpful number (see previous cautions about small businesses) you can see how it is faring as a % of sales as well. This is attention-directing information at its best!

Ratio, trend and comparative analysis can help you help

your clients make better decisions…by the numbers!



Analysis

Limitation, 2 Overview, 2 Vertical, 17

Asset Utilization, 7 Averages, 2 Balance sheet

Vertical analysis, 17 COGS %, 19 Collections, 10 Common Sizing, 17 Common-size statement, 17 Cost of goods sold, 8 Cost of Goods Sold, 19 Credit

Policy, 10 Sales, 11

Current Assets, 4 Current Liabilities, 4 Current Ratio, 4, 5 Days in Inventory, 9 Days in Receivables, 10 Debt Coverage Ratio, 15 Debt to Equity Ratio, 13 EBITDA, 15 Emergency, 6 Estimates, 2 Expansion, 6 Financial statements

Balance sheet Vertical analysis, 17

Fixed Asset Turnover, 12 How much can they borrow?, 14 How to read a ratio, 5 Industry

Averages, 2 Industry Average

Current Ratio, 5 Days in Inventory, 9 Days in Receivables, 10 Debt to Equity Ratio, 13 General rules, 7 Quick Ratio, 6

Inventory, 8 Inadequate, 9

Inventory Turnover, 8 Leverage, 13 Liquidity, 4, 5 Net Profit %, 20 Operating Cost %, 20 Operating Cycle, 7, 12 Profitability, 15 Quick Ratio, 4, 6 Receivables

Days in..., 10 Receivables Turnover, 10 Return on Assets, 16 Return on Equity, 16 Solvency, 2 Spoilage, 8 Vertical Analysis, 17 Working Capital, 4



Rip off this page to follow along with the calculations.

intermediate financial statement analysis: ratios, … financial statement analysis: ratios, trends,...

Documents