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# Financial Statement Analysis

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Method used by interested parties such as investors, creditors, and management to evaluate the past, current, and projected conditions and performance of the firm. Ratio analysis is the most common form of financial analysis.

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### Financial Statement Analysis

1. 1. Financial Statement Analysis
2. 2. Ratio & Risk Analysis  Comparison of financial ratios against: o Other company ratios. o Stock market averages. o Industry guidelines. o Lender policies. o Alternative investment opportunities. o Widely accepted standards. o Investor’s personal experience.  Use and limitations of financial ratios: o A reference point is needed. To be meaningful, most ratios must be compared to historical values, of the same firm, the firm’s forecasts, or ratios of similar firms. o Most ratios by themselves are not highly meaningful. They should be viewed as indicators, with several of them combined to paint a picture of the firm’s situation. o Year-end values may not be representative. Certain account balances are used to calculate ratios may increase or decrease at the end of the accounting period because of seasonal factors. Such changes may distort the value of the ratio. Average values should be used when they are available. o Ratios are subject to the limitations of accounting methods. Different accounting choices may result in significantly different ratio values. ABC Company BALANCE SHEET December 31 Year 2 Year 1 Current Assets: Cash and cash equivalents \$50,000 \$35,000 Trading securities (at fair value) 75,000 65,000 Accounts receivable 300,000 290,000 Inventory (at lower of cost or market) 290,000 275,000 Total current assets 715,000 665,000 Investments available-for-sale (at fair value) 350,000 300,000 Fixed Assets: Property, plant, and equipment (at cost) 1,900,000 1,800,000 Less: Accumulated depreciation (385,000) (350,000) 1,515,000 1,450,000 Goodwill 35,000 35,000 Total Assets \$2,615,000 \$2,450,000 Current liabilities: Accounts payable \$150,000 \$125,000 Notes payable 325,000 375,000 Accrued and other liabilities 220,000 200,000 Total current liabilities 695,000 700,000 Long-term Debt: Bonds and notes payable 650,000 600,000 Total liabilities 1,345,000 1,300,000 Stockholders' Equity: Common stock (100,000 shares outstanding) 500,000 500,000 Additional paid-in capital 350,000 350,000 Retained earnings 420,000 300,000 Total equity 1,270,000 1,150,000 Total liabilities and equity \$2,615,000 \$2,450,000
3. 3. ADDITIONAL INFORMATION December 31 Year 2 Sales \$1,800,000 Cost of goods sold (1,000,000) Gross profit 800,000 Operating expenses (486,970) Interest expense (10,000) Net income before income taxes 303,030 Income taxes (34%) (103,030) Net income after income taxes \$200,000 Net income after income taxes \$200,000 Outstanding shares 100,000 Earnings per share \$2 Operating cash flows \$255,000 Dividends for the year (per share) \$0.80 Market price per share \$12.00 Liquidity Ratios Defined Liquidity ratios demonstrate a company’s ability to meet its current obligations. Year 2 Year 1 Working Capital Current assets - Current liabilities Current assets \$715,000 \$665,000 Current liabilities 695,000 700,000 Working Capital \$20,000 (\$35,000) Year 2 Year 1 Current Ratio or Working Capital Ratio Current assets / Current liabilities Current assets \$715,000 \$665,000 Current liabilities 695,000 700,000 Current Ratio or Working Capital Ratio 1.03 0.95 Analysis Assuming the industry average is 1.5. The ratio and therefore ABC company’s ability to meet its short-term obligations, has improved, though it is low compared to the industry average. One widely accepted standard holds that a current ratio of 2-to-1 indicates that a company has sufficient liquid assets to meet its current liabilities.
4. 4. Acid-Test or Quick Ratio Year 2 Year 1 (Cash equivalents + Marketable securities + Net receivables) / Current liabilities Cash equivalents \$50,000 \$35,000 Marketable securities 75,000 65,000 Net receivables 300,000 290,000 425,000 390,000 Current liabilities 695,000 700,000 Acid-Test or Quick Ratio 0.61 0.56 Analysis Assuming the industry average is 0.80 The industry average of 0.80 is higher than ABC ratio, which indicates that ABC Company may have trouble meeting short-term needs. A quick ratio of 1:1 is normally regarded as satisfactory. Year 2 Year 1 Cash Ratio (Cash equivalents + Marketable securities) / Current liabilities Cash equivalents \$50,000 \$35,000 Marketable securities 75,000 65,000 125,000 100,000 Current liabilities 695,000 700,000 Cash Ratio 0.18 0.14 Activity Ratios Accounts Receivable Turnover Net credit sales / Average receivables Net credit Sales \$1,800,000 Beginning receivables 290,000 Ending receivables 300,000 Average receivables 295,000 Accounts Receivable Turnover Times 6.10 Analysis This ratio indicates the receivables’ quality and indicates the success of the firm in collecting outstanding receivables. Faster turnover gives credibility to the current and acid-test ratios. Accounts Receivable Turnover in Days Average receivables / (Net credit sales / 365) Beginning receivables \$290,000 Ending receivables 300,000 Average receivables \$295,000 Net credit Sales 1,800,000 365 Days 365 4,932 Accounts Receivable Turnover in Days days 59.82 Analysis This ratio indicates the average number of days required to collect accounts receivable. Inventory Turnover Cost of goods sold / Average inventory Cost of goods sold \$1,000,000 Beginning inventory \$275,000 Ending inventory 290,000 Average inventory 282,500 Inventory Turnover Times 3.54 Analysis This measure of how quickly inventory is sold is an indicator of enterprise performance. The higher the turnover, in general, the better the performance. Calculates the number of times inventory is turned in a year.
5. 5. Inventory Turnover in Days Average inventory / (Cost of goods sold / 365) Beginning inventory \$275,000 Ending inventory 290,000 Average inventory \$282,500 Cost of goods sold 1,000,000 365 Days 365 2,740 Inventory Turnover in Days Days 103.11 Analysis This ratio indicates the average number of days required to sell inventory. Operating Cycle A/R turnover in days + inventory tunover in days Accounts Receivable Turnover in Days 59.82 Inventory Turnover in Days 103.11 Operating Cycle Days 162.93 Analysis The operating cycle indicates the number of days between acquisition of inventory and realization of cash from selling the inventory. Working Capital Turnover Sales / Average working capital Sales \$1,800,000 Beginning working capital (35,000) Ending working capital 20,000 Average working capital (7,500) Working Capital Turnover Times 240 Analysis This ratio indicates how effectively working capital is used. Total Asset Turnover Net Sales / Average total assets Net sales \$1,800,000 Beginning total assets \$2,450,000 Ending total assets 2,615,000 Average total assets 2,532,500 Total Asset Turnover Times 0.71 Analysis This ratio is an indicator of how ABC Company makes effective use of its assets. A high ratio indicates effective asset use to generate sales. Accounts Payable Turnover Cost of goods sold / Average accounts payable Cost of goods sold 1,000,000 Beginning accounts payable 125,000 Ending accounts payable 150,000 Average accounts payable 137,500 Accounts Payable Turnover Times 7 Analysis This ratio indicates the number of times trade payables turn over during the year. A low turnover may indicate a delay in payment, such as from a shortage of cash.
6. 6. Days in Accounts Payable Average accounts payable / (Cost of goods sold / 365) Beginning accounts payable \$125,000 Ending accounts payable 150,000 Average accounts payable \$137,500 Cost of goods sold 1,000,000 365 Days 365 2,740 Days in Accounts Payable Days 50.19 Analysis This ratio indicates the average length of time trade payables are outstanding before they are paid. Profitability Ratios Defined Profitability ratios indicate a company’s ability to earn a satisfactory return on sales, total assets, and invested capital. Net Profit Margin Net income / Net sales Net income \$200,000 Net sales 1,800,000 Net Profit Margin 11.11% Analysis This ratio indicates profit rate, when used with the asset turnover ratio, indicates rate of return on assets. Return on Total Assets Net income / Average total assets Net income \$200,000 Beginning total assets \$2,450,000 Ending total assets 2,615,000 Average total assets 2,532,500 Return on Total Assets 7.9% Return on Investment (Net income + Interest expense (1 - Tax rate)) / Average Long-term liabilities + Equity Net Income \$200,000 Interest expense (1 - Tax rate) 6,600 \$206,600 Beginning Long-term liabilities \$600,000 Ending Long-term liabilities 650,000 Beginning Equity 1,150,000 Ending Equity 1,270,000 Average long-term liabilities + Equity 1,835,000 Return on Investment 11.3% Analysis ROI measures the performance of the firm without regard to the method of financing. Return on Common Equity (Net income - Preferred dividends) / Average common equity Net income \$200,000 less Preferred dividends 0 \$200,000 Beginning Equity 1,150,000 Ending Equity 1,270,000 Average common equity 1,210,000 Return on Common Equity 16.5%
7. 7. Net Operating Margin Percentage Net operating income / Net sales Gross Profit \$800,000 Operting expenses 486,970 Net operating income \$313,030 Net sales 1,800,000 Net Operating Margin Percentage 17.39% Gross (Profit) Margin Percentage Gross (profit) margin / Net sales Net Sales \$1,800,000 Cost of Goods Sold 1,000,000 Gross (profit) margin \$800,000 Net Sales 1,800,000 Gross (Profit) Margin Percentage 44.44% Operating Cash Flow Per Share Operating cash flow / Common shares outstanding EBIT \$313,030 Depreciation 45,000 Taxes (103,030) Operating cash flows \$255,000 Common shares outstanding 100,000 Operating Cash Flow Per Share per share \$2.55 Investor Ratios Degree of Financial Leverage Earnings before interest and taxes / Earnings before taxes Earnings before interest and taxes \$313,030 Earnings before taxes 303,030 Degree of Financial Leverage 1.033 Analysis The degree of financial leverage is the key factor by which net income will change with a change in earnings before interest and taxes. The degree of financial leverage indicates the leverage factor for recurring earnings. Earnings Per Share (Net income - Preferred dividends) / Weighted average number of common shares outstanding Net income \$200,000 Preferred dividends 0 \$200,000 Beginning common shares 100,000 Ending common shares 100,000 Average common shares 100,000 Earnings Per Share per share \$2 Price / Earnings Ratio Market price per share / Diluted earnings per share Market price per share \$12 Diluted earnings per share \$2 Price / Earnings Ratio \$6 Analysis This statistic indicates the investment potential of an enterprise; a rise in this ratio indicates that investors are pleased with the firm’s opportunity for growth.
8. 8. Dividend Payout Ratio Dividends per common share / Diluted earnings per share Dividends per common share \$0.80 Diluted earnings per share \$2 Dividend Payout Ratio 40% Analysis This ratio indicates the portion of current earnings being paid out in dividends. Dividend Yield Dividends per common share / Market price per common share Dividends per common share \$0.80 Market price per share \$12 Dividend Yield 6.67% Analysis This ratio indicates the relationship between dividends and market price. Year 2 Year 1 (Total stockholders' equity - Preferred stock) / Number of common shares outstanding Total stockholders' equity \$1,270,000 \$1,150,000 Preferred stock 0 0 \$1,270,000 \$1,150,000 Number of common shares outstanding 100,000 100,000 Book Value Per Share \$12.70 \$11.50 Analysis This ratio indicates the amount of stockholders’ equity that relates to each share of common stock. Note that preferred stock should be stated at liquidity value if other than book value. Long-Term Debt-Paying Ability Ratios Year 2 Year 1 Debt to Equity Total liabilities / Common stockholders' equity Total liabilities \$1,345,000 \$1,300,000 Common stockholders' equity \$1,270,000 \$1,150,000 Debt to Equity 1.06 1.13 Analysis This ratio indicates the degree of protection to creditors in case of insolvency. The lower this ratio, the better the company’s position. In ABC Company’s case, the ratio is very high, indicating that a majority of funds come from creditors. However, the ratio is improving. Year 2 Year 1 Debt Ratio Total liabilities / Total assets Total liabilities \$1,345,000 \$1,300,000 Total assets \$2,615,000 \$2,450,000 Debt Ratio 51.4% 53.1% Analysis This debt ratio indicates that more than half of the assets are financed by creditors.
9. 9. Times Interest Earned Recurring income before taxes and interest / Interest Net income before income taxes \$303,030 Interest expense 10,000 Recurring income before taxes and interest \$313,030 Interest expense 10,000 Times Interest Earned times 31.30 Analysis This ratio reflects the ability of a company to cover interest charges. It uses income before interest and taxes to reflect the amount of income available to cover interest expense. Operating Cash Flow to Total Debt Operating Cash Flow / Total Debt Operating cash flow \$255,000 Total debt 1,345,000 Operating Cash Flow to Total Debt 18.96% Analysis This ratio indicates the ability of the company to cover total debt with yearly cash flow. Z Score Defined A model designed by Edward Altman that indicates an unhealthy company that is headed for failure. Healthy score > 2.99 Unhealthy score < 1.81 Formula Z Score = 1.2(X1) + 1.4(X2) + 3.3(X3) + 6.0(X4) + 1.0 (X5) X1 = working capital / total assets X2 = retained earnings / total assets X3 = income before interest and taxes / total assets X4 = market value of equity / total liabilities X5 = sales / total assets Sample Company Information International R.R. Paper Macy's 3M Donnelley Gross Profit Margin 30.1% 45.7% 53.2% 24.2% EBIT Margin 3.2% 5.8% 23.2% 5.5% EBITDA Margin 15.9% 11.7% 27.6% 13.3% Pre-Tax Profit Margin 0.5% 3.4% 22.4% 2.0% Interest Coverage 1.2 2.4 27.9 1.6 Current Ratio 1.9 1.3 2.4 1.9 Quick Ratio 1.2 0.2 1.6 1.4 Leverage Ratio 4.4 4.4 2.0 4.1 Receivables Turnover 7.5 55.6 7.1 5.7 Inventory Turnover 7.5 2.6 4.3 14.1 Asset Turnover 0.9 1.1 0.9 1.1 Revenue to Assets 1.0 1.2 0.9 1.1 Return on Invested Capital 1.5% 3.8% 20.8% 1.4% Return on Assets 80.0% 2.2% 13.8% 90.0% Debt/Common Equity Ratio 1.51 1.58 0.35 1.61 Total Debt/ Equity 1.57 1.73 0.45 1.61