Financial StatementsAnalysisLecture 6Part 1: Ratio analysis
Lecture ObjectivesBy the end of this lecture you should be able to: Discuss the role of accounting information financialstatement analysis Conduct performance analysis based on the 5main ratio categories Interpret the ratios Explain drivers of profitability and growth Discuss the role and importance of cashflowanalysis Discuss other accounting & non-financialinformation in the annual reports
(i)AssessingStrategicDirection(ii)FinancialStatementAnalysis(iii)Stock MarketAssessmentThe General Framework• Assessing strategiccapability• Taking action to add value• Finding information oncompanies & their markets• Accounting for profit• Accounting for cash• Comparative financialanalysis• Share price movements•Short-term share valuation•Long-term share valuation
Financial Statement AnalysisFSA provides business owners andother interested parties with specifictechniques to analyse theinformation in financial statementsto uncover the soundness of priordecisions for survival and growth ofthe business.
Financial Statement AnalysisFinancial statement analysis involvesanalysing the financial information providedin company’s annual report to:Provide information about the organisation’s: Past performance Present condition Future performanceAssess the organisation’s: Earnings in terms ofpower, persistence, quality and growth Solvency
Effective Financial Statement AnalysisRequires that you: Understand the nature of the industry in which theorganisation works. This is an industry factor. Understand that the overall state of the economymay also have an impact on the performance ofthe organisation.→ Financial statement analysis is more than just“crunching numbers”; it involves obtaining abroader picture of the organisation in order toevaluate appropriately how that organisation isperforming.
Effective Financial Statement AnalysisTo perform an effective financial statementanalysis, you need to be aware of theorganisation’s: business strategy objectives annual report and other documents likearticles about the organisation in newspapersand business reviews.These are called specific/unique organisationalfactors.
Uses of Accounting Information• measure how much dividend might be paid• provide assurance of financial strength to creditors• provide a basis for measuring future growth forstock market analysis• measure mgmt performance in an agency context• provide the basis of taxation• give employees an idea of company’s strength• provide convenient templates for financialplanning• assist in setting performance targets• assist in imposing restrictions on managers
Tools of Financial Statement AnalysisFinancial ratio analysis is the commonly used tools forfinancial statement analysisComparative analysis Cross sectional analysis across sector Time series/Trend analysis within the company Time series/Trend analysis with other companies orcompetitorsBenchmarks: Past period achievements Budgeted achievements Other business achievements Averages of business achievements in the same area
Financial Ratio Analysis Financial ratio analysis involves calculating andanalysing ratios that use data from one, two ormore financial statements. Ratio analysis also expresses relationshipsbetween different financial statements. Financial Ratios can be classified into 5 maincategories: Profitability ratios Asset management or activity ratios Liquidity or short-term solvency ratios Gearing ratios Investment ratios
Financial Ratio AnalysisInvestmentProfitabilityLiquidityEfficiency/activity orassets mgmtGearingCategoriesof ratios
Financial Ratio AnalysisProfitability ratios4 elements of the profitability analysis: Analysing on sales and trading margin (cost of sales)◦ focus on gross profit Analysing on the control of operating expenses (O/Hs)◦ focus on net operating profit (EBITDA) Analysing on the amount of interest and tax paido focus on net profit after interest and tax (NOPAT) Assessing the return on assets (ROA) and return onequity (ROE).Profitability 
Income Statement Ratios forAssessing Operating ManagementCommon-sized income statements facilitatecomparisons of key line items across time anddifferent firms.The following ratios are helpful :i. Gross profit margin (by function only).ii. Earnings Before Interest, Taxes, Depreciation &Amortization (EBITDA) margin.iii. Net Operating Profit After Tax (NOPAT) margin.Profitability 
Profitability RatiosProfitability Gross Profit MarginMeasures the profitability of sales, less direct costs ofsales:The gross profit margin is an indicator of:• The price premium that a firm’s product commands inthe market,• The efficiency of a firm’s procurement and/orproduction process.
NOPAT and EBITDA Margins The EBITDA margin eliminates the significant non-cash expensesof depreciation and amortization along with interest and taxes:Profitability RatiosProfitability * NOPAT = Net profit + interest expense after tax [Palepu et al., p.211]• The NOPAT margin provides a comprehensive measure ofoperations:84/2000 = 4.2%
Profitability RatiosReturn on capital employed (ROCE)Profitability Return on Equity (ROE) measures overall profitabilityROE is a comprehensive measure of and is a goodstarting point to systematically analyze firm performance.
Profitability RatiosProfitability Alternative calculation of ROENet assets = Total assets minus all liabilitiesPalepu et al., p. 211
Profitability RatiosAlternative calculation of ROEProfitability  Spread is the incremental effect from introducing debt into the capitalstructure. Positive effect of borrowing is when the operating ROA isgreater than the cost of browning. That is, firms that do not earn adequateoperating ROA to pay for interest cost reduce their ROE by borrowing.
Financial Leverage AnalysisBorrowing allows a firm access tocapital, but increases the risk ofownership for equity holders.Analysis of leverage can be performed onboth current and non-current debts:1. Liquidity analysis relates to evaluating currentliabilities2. Solvency analysis relates to longer termliabilitiesLiquidity 
The following ratios attempts to measurethe ability of a firm to pay its currentobligations:Liquidity or Short-Term Solvency ratiosLiquidity 
Short-term funds managementWorking capital management is important as itsignals the firm’s ability to meet short term debtobligations.Liquidity Liquidity or Short-Term Solvency ratios
Solvency AnalysisBeyond short-term survival, solvency measures theability of a firm to meet long-term obligations.Several useful ratios used to analyze solvency withshareholders’ equity as a denominator are:Gearing 
Solvency RatiosLong term funds managementMeasures the riskiness of business in terms of debt gearing.Gearing 
Solvency AnalysisRatios that specifically address the ability to payinterest on debts are:Gearing 
Asset Management [activity ration]Asset management is a key indicator ofhow effective a firm’s management is.Asset turnover may be broken into twoprimary components:1. Working capital management2. Non-current asset managementEfficiency/activity or assets mgmt 
Working Capital ManagementWorking capital is the difference between currentassets and current liabilities i.e. CA-CLKey ratios useful to analyzing the management ofworking capital include:a) Operating working capital (OWC)- distinguishes between operating current assets (i.e.receivables, inventories and payables) and financingcurrent assets (cash, marketable securities and notespayable)Efficiency/activity or assets mgmt 
Working Capital Management-cont.b) Inventory managementEfficiency/activity or assets mgmt c) Debtors managementd) Creditors management* Average daily net credit sales = net credit sales / 365
Non-current Asset (NCA) ManagementIt is concerned with utilisation of firm’s non-currents i.e. efficiency in using net fixed assets:NCA = net property, plant & equipment(PP&E), intangibles and other assetsEfficiency/activity or assets mgmt Example of noninterest bearing non-current liabilities: Deferredtaxes
Investment RatiosBased on the share markets perception of the company709603096030702.50.073Investment = £0.073= £0.03x 100 = 42.86%= 34.25 timesNo. of shares = 1,000 – 40 = 960, 40 = reserves or retained earning
Interpreting ratio analysis (see ratioresults in earlier lecture)Profitability ratios: Benchmarks CompanyGross Profit Margin Industry 25% 25%Net Profit Margin Industry 7% 3.5%Return on CapitalEmployedIndustry 12% 7.7%Return on Equity Industry 20% 7%Asset Management ratios:Inventory Turnover Industry 6 times 7.5 timesAsset Turnover Industry 4 times 1.21 times
Interpreting ratio analysisLiquidity ratios: Benchmarks CompanyCurrent Ratio Ideal standard 2:1 1.43:1Quick Ratio Ideal standard 1:1 1:1Financial Structure ratios:Debt/Equity Industry 60% 30%TIE (TimesInterest Earned )Standard benchmark:Between 3 and 5.Below 3 risky.Above 5 very favourable6.25
Assessing the Sustainable Growth RateA comprehensive measure of a firm’sratios is the sustainable growth rate:Sustainable growth rate measures theability of a firm to maintain its profitabilityand financial policies.Measure dividend policy7%x (1 – 0.4286) = 4%
Cash Flow Analysis The ratio analysis previously discussed usedaccrual accounting. Cash flow analysis can provide further insights intooperating, investing, and financing activities. All companies using IFRS are required to include astatement of cash flows in their financialstatements.◦ Differences in reporting cash flow information allow forvariation across firms that complicate comparisons.◦ Analysts can make adjustments to net income to arrive atfree cash flows, a commonly used metric for financialanalysis.
Analyzing Cash Flow InformationAnalysis of the statement of cash flows helpedanswer a number of questions such as:Operating activitiesHow strong is the firm’s internal cash flow generation?How well is working capital being managed?Investing activitiesHow much cash did the company invest in growth assets?Financing activities• What type of external financing does the company rely on?• Did the company use internally generated funds forinvestments?• Did the company use internally generated funds to paydividends?
Cash flow AnalysisOpening cash & cash equivalents £1,788mplusNet cash in £3,960mLessInvestments £5,974mPlusFinance raised £3,615mPlusForeign exchange gains £120mNet cash balance at year end £3,509mQuestionDoes spending fit with story given in the narrative?Look for special items e.g. purchase of intangibles; bigincrease in borrowings
Useful cash flow metrics Cash Flow / Maturing Obligations Operating Cash Flow (from the CFS) Current Liabilities Cash Flow per share Operating Cash Flow (from the CFS) No of shares in issue(Weighted Average.) Free cash flow per share Free cash flow No of shares in issue. Most useful BUT be warned – no regulatory definitions Free cash flow = C – I = cash from operation – cash invested inoperation Measures cash available for discretionary expenditure oncapital, projects, new stores, refurbishments, extra dividends, etc.
Free Cash FlowEBIT+ Depreciation+ Proceeds of disposals/ other income- Interest payments (netted off against any receipts)- Cash taxation figure (not necessarily P&Lfigure; but use it if you don’t have anythingelse – but check creditors)- Dividend payments (netted off against anyreceipts)= “Common sense” FREE CASH FLOWExample using income statement
Example Free Cash Flow inTesco£ m 2009 2008Cash from operations 3960 3343Other income 1354 1056FX gains/losses 120 (55)Interest paid (net) (472) (282)Tax paid (456) (346)Dividends paid (net) (814) (704)Free Cash Flow (FCF) 3692 3012It can serve as a proxy for measuring changes in earnings pershareFree cash flow: Signals a companys ability to pay debt, Pay dividends, Buy back shares and facilitate the growth of business.Give a preliminary prediction concerning future share prices, e.g. when a firmsshare price is low and FCF is on the rise, the prospects are good that earningsand share price will soon be on the rise. Thus, high free cash flow per sharemeans that earnings per share should potentially be high as well.Example using cash flow statement
Concluding comments on ratiosThere are two primary tools in financial analysis:Ratio analysis – to assess how various line itemsin financial statements relate to each other and tomeasure relative performance.Cash flow analysis – to evaluate liquidity and themanagement of operating, investing, andfinancing activities as they relate to cash flow.Both forms of analyses must be evaluated whileconsidering whether firm performance isconsistent with the strategic initiatives ofmanagement.
The Importance of Accounting Informationand Analysis• Accounting practices govern the types ofdisclosures made in the financial statements.• Non-financial accounting information is equallyimportant.• Understanding both financial and non-financialaccounting information allows the businessanalyst to effectively use the informationdisclosed to assess the value of the companies.Other Accounting & Non Financial Information
Other Accounting & Non Financial Information• Narrative statements• Chairman’s report• Directors report• Auditor’s report• Corporate governance reportOther reports• Value-added• Segmental report• Statement of corporate objectives• Statement of future prospects• Ethical report / CSR• Employees report
Chairman’s Statement• overall trading conditions during the period, currentclimate & general outlook• performance achieved by each activity, currenttrading & future prospects• items of special interest• changes in the board, comments on directors andother employees and efforts of mgmt team andworkforce• company’s strategy and plans for the future• political/social/economic comments about govt.,tax, accounting standards etc.
Director’s Report• Activities and trading results• Financial review* cash from operations & other cash inflows* types of accounting standards adopted* maturity profile* capital structure*ability to remain a going concern• Operating review (Operating & Financial Review/business review]* marketing & capital expenditure* diversification, acquisition, growth* impact of factors in the environment• Directors* interest in shares* interest of directors’ close families
Auditor’s Report• identification of addressee• identification of financial statements audited• respective responsibilities of directorsand auditors* basis & type of audit opinion• signatures of auditors• date of audit report
Corporate Governance Report• Report by audit committee• Report by remuneration committee* remuneration policy*share option schemes*retirement benefits, service agreements*long-term incentive plan*annual incentive awards*directors emoluments
Volkswagen Group – Annual Report 2011Value added generated by the Volkswagen Group – Appropriation of fundsAppropriation of funds in € million 2011 % 2010 %to shareholders (dividend) 1,406 2.9 1,034 3.1to employees(wages, salaries, benefits) 23,854 50.0 19,027 57.8to the state (taxes, duties) 4,525 9.5 3,105 9.5to creditors (interest expense) 3,530 7.4 3,563 10.8to the Company (reserves) 14,393 30.2 6,193 18.8Value added 47,709 100.0 32,922 100.0Volkswagen Group – Annual Report 2011Value added generated by the Volkswagen Group – Source of fundsSource of funds in € million 2011 2010Sales revenue 159,337 126,875Other income 13,125 10,787Cost of materials -104,648 -79,394Depreciation and amortization -10,346 -10,097Other upfront expenditures -9,759 -15,250Value added 47,709 32,922http://annualreport2011.volkswagenag.com/financialstatements.html?cat=n
Segmental Reportproduct/service Turnover Operating profitBrass Hotels & Resorts X XBrass Leisure X XOther Activities X XXX XXcountryUnited Kingdom X XUnited States X XRest of Europe X XXX XX
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