Chapter+19+-+Financial+Statement+Analysis

__**SO 1 - 6**__ Homework: E19-7, E19-8, E19-9 Highlights: analyzing financial statements involves an inspection of three characteristics of a company: ** liquidity, solvency and ** ** profitability **

- **short-term creditors** (e.g., banks and suppliers) focus on ** liquidity ** (short-term ability of firm to pay its debts as they become due and to meet unexpected shortfalls in cash)

- **long-term creditors** (e.g., bondholders) and corporate shareholders focus on ** profitability ** (operating success of firm over specified period of time) and ** solvency ** (ability of firm to satisfy its debt obligations over the long term)

- **comparisons of financial statement data can be made**

(i) on an **intracompany basis** wherein this year's figures or percentages are compared with numbers for the __same__ company from previous years (ii) on an **intercompany basis** wherein this year's figures or percentages are compared with numbers from __competing__ firms within the same industry (iii) against **industry averages** or **norms** or **industry rules of thumb (ROT)**

- percentage comparisons tend to be more informative than dollar comparisons when companies of varying sizes are being examined

- **horizontal or dynamic analysis** (**two-year comparative analysis and** **multiple-year trend analysis** **-> see chapter 8 in grade 11 accounting)** measures financial data over time and looks at company figures on an intracompany basis

- **vertical or static analysis** (**common-size analysis** -> **see chapter 8 in grade 11 accounting)** expresses financial data as a percentage of a designated figure (base amount, i.e., total assets/total liabilities and equity on the balance sheet or net sales on the income statement) within the same time period and looks at company figures on both an intracompany and intercompany basis

- **ratio analysis** expresses **mathematical relationships between individual items of financial data** and looks at company figures on an intracompany, intercompany or industry average basis

- as previously stated, financial ratios express mathematical relationships between designated items found on financial statements
 * __Ratio analysis__**

- ratios may be expressed either as **percentages** (228%), **rates** (2.28 times) or **proportions** (2.28:1)

- **ratio analysis involves liquidity ratios, profitability ratios** and **solvency ratios**

(a) **current ratio** (or **working capital ratio**) measures a company's ability to pay its short-term debts as they become due
 * __Liquidity ratios__**


 * __current assets__**
 * current liabilities**

__$50__ $40

1.25:1

(b) **quick ratio** (or **acid-test ratio**) measures a company's ability to __immediately__ pay its short-term debts as they become due (and so inventory and prepaid expenses are removed from calculation)


 * __cash and cash equivalents, temporary (short-term) investments, net accounts receivable__**
 * current liabilities**

__$20__ $40

0.5:1

(c) **cash current debt coverage** measures a company's ability to pay its short-term debts as they become due and uses cash flow statement figures and balance sheet averages rather than year-end balance sheet figures only to improve accuracy


 * __net cash provided by operating activities (from cash flow statement)__**
 * average current liabilities (beginning liabilities + ending liabilities / 2)**

__$100__ ($70 + $90)/2

1.25 times

(d) **receivables turnover** measures how quickly a company can convert its receivables into cash (collect) in terms of the __number of times per year__ that outstanding receivables are collected from debtor customers


 * __net credit sales (credit sales only - credit returns)__**
 * average net receivables (beginning receivables + ending receivables / 2)**

__$1000__ ($50 + $150)/2

10 times/year

(e) **collection period** measures how quickly a company can convert its receivables into cash (collect) in terms of the __number of days on average__ it takes for outstanding receivables to be collected from debtor customers and is used to assess the effectiveness of the firm's credit and collection policies - as a rule of thumb, a firm's collection period should be roughly equivalent to that firm's typical credit term period


 * __365 days__**
 * receivables turnover**

__365__ 10

36.5 days

(f) **inventory turnover** measures how quickly a company can convert its inventory into cash (sell) in terms of the __number of times per year__ that inventory is completely sold and replaced


 * __cost of goods sold__**
 * average inventory** **(beginning inventory + ending inventory / 2)**

__$1000__ ($100 + $300)/2

5 times/year

(g) **days sales in inventory** measures how quickly a company can convert its inventory into cash (sell) in terms of the __number of days on average__ it takes for inventory to be completely sold and replaced


 * __365 days__**
 * inventory** **turnover**

__365__ 5

73 days

(h) **profit margin** (or **return on sales**) measures a company's ability to generate profits from its sales of goods and services using accrual-based figures
 * __Profitability ratios__**


 * __net income__**
 * net sales**

__$50__ $1000 x 100

5%

(i) **gross profit margin** measures a company's ability to generate gross profits from its sales of goods and services using accrual-based figures - high volume firms (e.g., grocery stores) generally have lower gross profit margins while low volume firms (e.g., car dealers) generally have higher gross profit margins


 * __gross profit (net sales - cost of goods sold)__**
 * net sales**

__$600__ $1000 x 100

60%

(j) **cash return on sales** measures a company's ability to generate cash from its sales of goods and services


 * __net cash provided by operating activities (from cash flow statement)__**
 * net sales**

__$60__ $1000 x 100

6%

(k) **asset turnover** measures how efficiently a company employs its assets to generate sales


 * __net sales__**
 * average total assets (beginning assets + ending assets / 2)**

$1000 ($400 + $600) / 2

2 times

(l) **return on assets** measures how efficiently a company employs its assets to generate profits


 * __net income__**
 * average total assets (beginning assets + ending assets / 2)**

__$100__ ($900 + $1100) / 2 x 100

10%

(m) **return on common shareholders' equity** (or **return on investment - ROI**) measures how efficiently a company employs its equity to generate profits - as this is a ratio involving __common__ shareholders' equity only, legal share capital and dividends in arrears on __preferred__ shares must be deducted from total equity beforehand - companies often benefit from **leveraging** (or **trading on equity**) when they borrow money (by issuing bonds or cumulative preferred shares or signing notes payable) in order to purchase assets that hopefully increase earnings on common stock (by earning more than the interest paid on the debt)


 * __net income__**
 * average common shareholders' equity (beginning common equity + ending common equity / 2)**

__$1000__ ($8000 + $12000) / 2 x 100

10%

(n) **book value per common share** represents the equity of each common share in the net assets of the company - once again, as this is a ratio involving __common__ shareholders' equity only, __legal__ share capital and __dividends in arrears__ on __preferred__ shares must be deducted from total equity beforehand


 * __total common shareholders' equity__**
 * number of outstanding common shares**

__$10000__ 1000 shares

$10/share

(o) **cash flow per common share** measures the amount of cash generated by each common share


 * __net cash provided by operating, investing and financing activities (from cash flow statement)__**
 * number of outstanding common shares**

__$10000__ 100000 shares

$0.10/share

(p) **earnings per common share** **(EPS)** measures the amount of profits generated by each common share and is a good indicator of the amount of dividends that may be paid out by the firm - as this is a ratio involving __common__ shares only, __dividends in arrears__ on __preferred__ shares must be deducted from net income beforehand


 * __net income__**
 * number of outstanding common shares**

__$10000__ 5000 shares

$2/share

(q) **price-earnings ratio (P/E ratio)** measures the market affordability of publicly-traded common shares relative to their earnings potential - industry-average P/E ratios are used to determine the relative affordability of a firm's common shares vis-a-vis common shares of competitor firms


 * __current market share price__**
 * EPS (common share)**

__$5/share__ $.50/share

10 times

(r) **payout ratio** measures the percentage of earnings distributed to shareholders as cash dividends


 * __total cash dividends__**
 * net income**

__$1000__ $10000 x 100

10%

(s) **dividend yield** measures the annual rate of return on a shareholder's investment expressed in terms of cash dividends received


 * __annual cash dividend per share__**
 * current market share price**

__$2/share__ $100/share x 100

2%

(t) ** debt to total assets ** (or ** debt ratio ** ) measures the percentage of total assets contributed by creditors
 * __Solvency ratios__**


 * __total liabilities__**
 * total assets**

__$20000__ $50000 x 100

40%

(100% minus debt ratio always equals the **equity ratio [total equity/total assets]**, or the percentage of total assets contributed by shareholders)

(u) **debt to equity ratio** compares total assets contributed by creditors to total assets contributed by shareholders


 * __total liabilities__**
 * total shareholders' equity**

__$60000__ $40000 x 100

133%

(v) **interest coverage** (or **times interest earned ratio**) measures a company's ability to meet its interest obligations as they become due using accrual-based figures


 * __income before interest and income tax expense__**
 * annual interest expense**

__$100000__ $10000

10 times

(w) **cash interest coverage** measures a company's ability to meet its interest obligations as they become due using available cash


 * __income before interest, income tax, amortization and depreciation expense (EBITDA)__**
 * annual interest expense**

__$80000__ $10000

8 times

(x) ** cash total debt coverage **measures a company's ability to meet its overall debt obligations using cash from normal operations


 * __net cash provided by operating activities (from cash flow statement)__**
 * average total liabilities (beginning liabilities + ending liabilities / 2)**

__$10000 __ ($90000 + $110000) / 2

0.1 times

__**Limitations of financial analysis**__ - financial ratios may be limited in their effectiveness to aid in decision-making given that financial statements

(i) contain estimates of financial figures (e.g., allowance for doubtful accounts, capital asset amortization, warranties and contingencies) (ii) list assets at historical cost prices and not updated market values (iii) differ in terms of accounting principles employed from company to company (e.g., inventory cost methods) (iv) may contain unusual year-end account balances not typical of average balances during the year (v) may not fully take into account the diversification of operations within a single firm making comparisons difficult and so, public disclosure of significant operations within diverse industries (segment information disclosures) are legally required in the notes to the financial statements