Financial statement analysis involves analyzing financial documents like income statements, balance sheets, and cash flow statements to evaluate a business's performance and financial position over time and in comparison to industry averages. It provides information on profitability, liquidity, asset management, financial structure, and market value. For Walker Ltd, an investor is considering shares, so the summary evaluates the company's performance, position, and recommends purchasing shares based on acceptable ratios, strong industry prospects, sales growth, cash flows, and favorable return on equity compared to industry averages.

1. Financial Statement Analysis Asset management portfolios

2. Business Survival: There are two key factors for business survival: Profitability Solvency Profitability is important if the business is to generate revenue (income) in excess of the expenses incurred in operating that business. The solvency of a business is important because it looks at the ability of the business in meeting its financial obligations.

3. Financial Statement Analysis Financial Statement Analysis will help business owners and other interested people to analyse the data in financial statements to provide them with better information about such key factors for decision making and ultimate business survival.

4. Financial Statement Analysis Purpose: To use financial statements to evaluate an organisation’s Financial performance Financial position. To have a means of comparative analysis across time in terms of: Intracompany basis (within the company itself) Intercompany basis (between companies) Industry Averages (against that particular industry’s averages) To apply analytical tools and techniques to financial statements to obtain useful information to aid decision making.

5. Financial Statement Analysis Financial statement analysis involves analysing the information provided in the financial statements to: Provide information about the organisation’s: Past performance Present condition Future performance Assess the organisation’s: Earnings in terms of power, persistence, quality and growth Solvency

6. Effective Financial Statement Analysis To perform an effective financial statement analysis, you need to be aware of the organisation’s: business strategy objectives annual report and other documents like articles about the organisation in newspapers and business reviews. These are called individual organisational factors.

7. Effective Financial Statement Analysis Requires that you: Understand the nature of the industry in which the organisation works. This is an industry factor. Understand that the overall state of the economy may also have an impact on the performance of the organisation. -> Financial statement analysis is more than just “crunching numbers”; it involves obtaining a broader picture of the organisation in order to evaluate appropriately how that organisation is performing

8. Tools of Financial Statement Analysis: The commonly used tools for financial statement analysis are: Financial Ratio Analysis Comparative financial statements analysis: Horizontal analysis/Trend analysis Vertical analysis/Common size analysis/ Component Percentages

9. Financial Ratio Analysis Financial ratio analysis involves calculating and analysing ratios that use data from one, two or more financial statements. Ratio analysis also expresses relationships between different 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

10. 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 return on equity

11. Profitability Ratios Gross Profit % = Gross Profit * 100 Net 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 other expenses. 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

12. Liquidity or Short-Term Solvency ratios Short-term funds management Working capital management is important as it signals the firm’s ability to meet short term debt obligations. For example: Current ratio The ideal benchmark for the current ratio is $2:$1 where there are two dollars of current assets (CA) to cover $1 of current liabilities (CL). The acceptable benchmark is $1: $1 but a ratio below $1CA:$1CL represents liquidity riskiness as there is insufficient current assets to cover $1 of current liabilities.

13. Liquidity or Short-Term Solvency ratios Working Capital = Current assets – Current Liabilities Current Ratio = Current Assets Current Liabilities Quick Ratio = Current Assets – Inventory – Prepayments Current Liabilities – Bank Overdraft

14. Asset Management or Activity Ratios Efficiency of asset usage How well assets are used to generate revenues (income) will impact on the overall profitability of the business. For example: Asset Turnover This ratio represents the efficiency of asset usage to generate sales revenue

15. Asset Management or Activity Ratios Asset Turnover = Net Sales Average Total Assets Inventory Turnover = Cost of Goods Sold Average Ending Inventory Average Collection Period = Average accounts Receivable Average daily net credit sales* * Average daily net credit sales = net credit sales / 365

16. 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 and equity. A ratio of 1 indicates that debt and equity funding are equal (i.e. there is $1 of debt to $1 of equity) whereas a ratio of 1.5 indicates that there is higher debt gearing in the business (i.e. there is $1.5 of debt to $1 of equity). This higher debt gearing is usually interpreted as bringing in more financial risk for the business particularly if the business has profitability or cash flow problems .

17. 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

18. Market Test Ratios Based on the share market's perception of the company. For example: Price/Earnings ratio The higher the ratio, the higher the perceived quality of the earnings by the share market.

19. Market Test Ratios Earnings per share = Net Profit after tax Number 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

20. 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 of 5 years to identify what the growth in sales is over this period.

21. Vertical analysis/Common size analysis/ Component Percentages All items are expressed as a percentage of a common 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

22. Limitations of Financial Statement Analysis We must be careful with financial statement analysis. Strong financial statement analysis does not necessarily 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 to collapse.

23. Illustration: Financial statement analysis The following financial statements of Walker Ltd were prepared in accordance with New Zealand GAAPs. Walker Ltd is a diversified enterprise with 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 purchasing shares in the company. Relevant ratios need to be selected and calculated and a report needs to be written for the investor. The report should evaluate the company’s performance and position

24. Walker Ltd Statement of Financial Position as at 31 March

25. Walker Ltd Statement of Financial Performance for year ended 31 March

26. Walker Ltd Statement of Cash Flows for the year ended 31 March

27. Additional information: Credit purchases for the year 2010 were $2,142,800. General prospects for the major industries in which Walker is involved look good with a forecast glut of oil set to reduce the cost of production and world demand for plastic remaining strong. Benchmarks: There are no exact benchmarks for Walker Ltd because it is a diversified company. The following are average indicators that relate to the plastic retailing and manufacturing industries for the year 2010. 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%

28. Relevant ratios Important note: The calculations of the ratios in this illustration did not use “averages” for total assets, equity and inventory. The 2009 and 2010 year end figures were used and this is a slight variation to the formulas provided. Profitability ratios: Benchmarks 2009 2010 Gross Profit Margin Industry 25% 22% 22.7% Net Profit Margin Industry 7% 7.1% 6.1% Return on Assets 12% 15.6% 15.5% Return on Equity Industry 20% 32% 26%

29. Asset Management ratios: Benchmarks 2009 2010 Inventory Turnover Industry 6 % 5.8 times 5.58 times Asset Turnover Not given 2.2 2.53

30. Liquidity ratios: Benchmarks 2009 2010 Current Ratio Ideal standard 2:1 Acceptable standard 1:1 1.78:1 1.70:1 Quick Ratio Ideal standard 2:1 Acceptable standard 1:1 0.85:1 0.69:1 Days Payable Standard 30 days Credit purchases not available 49.19 days

31. Financial Structure ratios: Benchmarks 2009 2010 Debt/Equity Industry 0.6:1 Standard benchmark 1:1 1.05: 1 0.67:1 TIE Standard benchmark: Between 3 and 5. Below 3 risky. Above 5 very favourable 10.14 times 39.74 times

32. Report For the investor considering the purchase of shares in the company, the return they will earn is the key financial factor but an overall evaluation of the company’s performance and position is also important to get a better picture of how well the company is actually doing. ROE in 2010 is 26%. Whether or not this is attractive depends on the perceived riskiness of this investment and other alternatives available but this return is certainly more attractive than current bank interest rates. ROE has decreased by 4% but the company’s 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 2010.

33. Profitability The NP% and ROA ratios show a small downward trend in % over the 2 year period. ROE% ratio show a more significant decrease but is still better than the industry average. Gross Profit Margin is slightly unfavourable at about 2.3% below the industry benchmark of 25%. The horizontal analysis information show that Sales have increased by 20%. However operating costs have 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 being generated from asset usage

34. Liquidity Current ratios of 1.78:1 (2009) and 1.70: 1 are at above acceptable levels but below ideal level. Quick ratios appear more of a concern being below acceptable levels in both years and even more so in 2010 (0.69:1). Raises some concerns over the liquidity of the business and inventory management (although IT ratio only shows a slight decline in 2010). Days Payable is a concern as there may be poor debt payment management.

35. Financial Structure Although slightly higher than D/E industry benchmark (0.67:1), business has become less risky due to the significant repayment of loan in 2010. 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 (increased from 160,600 to 185,000). Spending under investing activities suggest more growth. Repayment of debt under financing activities imply restructuring of business to have more equity funding rather than debt funding.

36. Given: the strong forecast for the industry (ie general prospects looking good and world demand for plastic products remaining strong), the sales growth in this business, acceptable ratios as they are quite close to the industry averages, good cash flows from operating activities and favourable ROE, although it has decreased, it is still better than the industry average ROE. => it is recommended that the investor purchase shares in the Walker Ltd company. Recommendation