lecture 5 financial statement analysis
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Chapter 6Van Horne and WachowiczFundamentals of Financial Management (11/e)
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Financial statements (or financial reports) areformal records of the financial activities of abusiness, person, or other entity. Financial
statements provide an overview of a business orperson's financial condition in both short andlong term.
All the relevant financial information of a
business enterprise, presented in a structuredmanner and in a form easy to understand, arecalled the financial statements. There are fourbasic financial statements:
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Balance sheet: also referred to as statement of financialposition or condition, reports on a company's assets,liabilities, and net equity as of a given point in time.
Income statement: also referred to as Profit and Lossstatement (or a "P&L"), reports on a company's income,expenses, and profits over a period of time. Profit & Lossaccount provide information on the operation of theenterprise. These include sale and the various expensesincurred during the processing state.
Statement of retained earnings: explains the changes ina company's retained earnings over the reporting period.
Statement of cash flows: reports on a company's cashflow activities, particularly its operating, investing andfinancing activities.
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Financial statement analysis refers to anassessment of the viability, stability and
profitability of a business, sub-business orproject. It is performed to prepare reports using ratios
that make use of information taken from
financial statements and other reports. Thesereports are usually presented to topmanagement as one of their bases in makingbusiness decisions.
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Profitability- its ability to earn income and sustain growthin both short-term and long-term. A company's degree ofprofitability is usually based on the income statement,which reports on the company's results of operations;
Solvency- its ability to pay its obligation to creditors andother third parties in the long-term;
Liquidity- its ability to maintain positive cash flow, whilesatisfying immediate obligations;
Stability- the firm's ability to remain in business in the long
run, without having to sustain significant losses in theconduct of its business. Assessing a company's stabilityrequires the use of both the income statement and thebalance sheet, as well as other financial and non-financialindicators.
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Past Performance - Across historical time periodsfor the same firm (the last 5 years for example),
Future Performance - Using historical figures andcertain mathematical and statistical techniques,including present and future values, Thisextrapolation method is the main source of errorsin financial analysis as past statistics can be poorpredictors of future prospects.
Comparative Performance - Comparisonbetween similar firms.
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The tools used to assess the financial condition and performance ofthe firm is financial ratios. In finance, a financial ratio or accountingratio is a ratio of two selected numerical values taken from anenterprise's financial statements.
There are many standard ratios used to try to evaluate the overallfinancial condition of a corporation or other organization. Financial ratios may be used by managers within a firm, by current
and potential shareholders (owners) of a firm, and by a firm'screditors.
Security analysts use financial ratios to compare the strengths and
weaknesses in various companies. If shares in a company are traded in a financial market, the marketprice of the shares is used in certain financial ratios.
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Liquidity Ratios:
Liquidity is the ability of an asset to be
converted into cash without a significantprice concession.
Liquidity ratios are used to measure a firmsability to meet short-term obligations. They
compare short-term liabilities to short-term(current) resources available to meet these
obligations.
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Current ratio shows a firms ability to cover itscurrent liabilities with its current assets
The higher the current ratio, the greater the abilityof the firm to pay its liabilities
Standard current ratio is 2:1
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This ratio concentrates on more liquid assets
It excludes less liquid inventory This ratio provides a more penetrating
measure of liquidity
Standard is 1:1
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Financial Leverage or Debt Ratios: Leverage or leveraging refers to the use of debt to
supplement investment or the degree to which an investoror business is utilizing borrowed money. Financial leveragetakes the form of a loan or other borrowings (debt), theproceeds of which are invested with the intent to earn agreater rate of return than the cost of interest. Companies that are highly leveraged may be at risk of
bankruptcy if they are unable to make payments on their debt;
they may also be unable to find new lenders in the future. Financial leverage is not always bad, however; it can increase the
shareholders' return on their investment and often there are taxadvantages associated with borrowing.
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It shows the extent to which the firm is financed by debt It tells the contribution of creditors for each unit of
money being provided by the shareholders (owners) Lower the ratio better for creditors because higher
cushion Sometimes preferred stocks are included as debt rather
than as equity Low ratio may attract more creditors
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It shows the percentage of firms assets
supported by debt financing
Higher ratio means higher financial risks Lower ratio means lower financial risks
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Total capitalization represents all long-term debtand shareholders equity. So, it is the total long-term debt and all types of equity of a companythat constitutes its capital structure.
It tells us the relative importance of ling-termdebt to the capital structure (long-term financing)of the firm
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Companies can finance their operations through eitherdebt or equity. The debt-to-capital ratio gives users anidea of a company's financial structure, or how it is
financing its operations, along with some insight into itsfinancial strength. The higher the debt-to-capital ratio,the more debt the company has compared to its equity.This tells investors whether a company is more prone to
using debt financing or equity financing. A company withhigh debt-to-capital ratios, compared to a general orindustry average, may show weak financial strengthbecause the cost of these debts may weigh on thecompany and increase its default risk.
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Ratios takes data from income statement and
balance sheet.
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Coverage ratios are designed to relate the financialcharges to its ability to service, or cover, them. It indicates a firms ability to cover interest charges, and
thus avoid bankruptcy. Higher the ratio, greater is the ability of the firm to cover
interest charges. A combination of debt ratios with coverage ratios may
give deeper insight about the ability of a firm to avoid debtrelated risks or financial risks.
A cash flow analysis is also necessary.
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Activity ratios, also known as efficiency or
turnover ratios, measure how effectively the
firm is using its assets.
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Provides insight into the quality of the firms receivablesand how successful the firm is in its collections. This ratio tells us the number of times account receivables
have been turned over during the year. If sales are seasonal, use year end receivables data not
correct. Use average of month end receivables data. In growth case, use average of beginning and end of year
receivables data. Analyze quality of receivables and its liquidity.
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It shows average collection period or state ofliquidity of receivables.
Receivable turnover in days should bereasonable according to standard of theindustry.
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The process of classifying accounts
receivables by their age outstanding as of a
given date. The analysis is based of the term of accounts
receivables (2/10, net 30).
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Firm may analysis its ability to pay suppliers
and its potential as credit customers.
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If purchase data not available cost of goods
sold may be used
Compare payables accounts with terms ofcredit
Beginning Inventory + Purchase COGS =Ending Inventory
Purchase =COGS + Ending Inventory
Beginning Inventory
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How effectively the firm is managing inventory. It tells
how many times inventory is turned over toreceivables through sales during the year
Consider seasonality and growth situations. Higher inventory turnover indicates higher efficiency.
Higher inventory turnover may increase stockout risk.
Stockout is not having enough inventory items ininventory to fill an order. IT ratio may be calculated separately for different
categories of products
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Operating Cycle The length of time from the commitment
of cash for purchases until the collection of receivablesresulting from the sale of goods or services.
Operating Cycle = Inventory turnover in days (ITD) +Receivable turnover in days (RTD)
Cash Cycle The length of time from the actual outlay of cashfor purchases until the collection of receivables resulting from
the sale of goods and services.Cash Cycle = Operating Cycle (ITD + RTD) Payable
turnover in days (PTD) Short operating cycle needs less resource
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Profitability ratios relate profits to sales and
investment.
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Gross Profit Margin= (Net Sales-Cost of
Goods Sold)/(Net Sales)
Net Profit Margin=(Net Profit after
taxes)/(Net Sales)
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