Financial Statement Analysis

Mary Low

Ratio Analysis
Shows the relative size of one financial statement component to another. Effective only when used in combination with other ratios, analysis, and information
Ratio Analysis involves methods of calculating and interpreting financial ratios in order to assess a firm's performance and status

Mary Low

Ratio Analysis
A single ratio by itself is not very meaningful.
The discussion of ratios will include the following types of comparisons.

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Mary Low

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 4 main categories:

Liquidity ratios Asset Management or Activity Ratios Debt Ratios Profitability Ratios

Mary Low

Ratio Analysis
Liquidity Ratios
Measure the short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash.

Short-term creditors such as bankers and suppliers are particularly interested in assessing liquidity. Ratios include the current ratio, the Quick ratio.

Mary Low

Liquidity ratios
For example: Current ratio Current Assets Current Liabilities This ratio is calculated in times. 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. A ratio of 5 : 1 would imply the firm has $5 of assets to cover every $1 in liabilities A ratio of 0.75 : 1 would suggest the firm has only 75c in assets available to cover every $1 it owes Too high Might suggest that too much of its assets are tied up in unproductive activities too much stock, for example?

Mary Low

Liquidity ratios
Quick Ratio = Current Assets Inventory Current Liabilities This ratio is calculated in times.
1:1 seen as ideal The omission of stock gives an indication of the cash the firm has in relation to its liabilities. A ratio of 3:1 therefore would suggest the firm has 3 times as much cash as it owes very healthy! A ratio of 0.5:1 would suggest the firm has twice as many liabilities as it has cash to pay for those liabilities. This might put the firm under pressure but is not in itself the end of the world!

Mary Low

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 All turnover ratios are calculated in times while all period ratios are calculated in days.
Mary Low

Asset Management or Activity Ratios

Asset Turnover = Inventory Turnover = Net Sales Total Assets Cost of Goods Sold Inventory = Inventory Cost of goods sold/365
Accounts Payable Annual Purchases/365 Accounts Receivable Average daily net sales*

Inventory Period

Average Payment Period (APP)

Average Collection Period =

* Average daily net sales = net sales / 365

Mary Low

Inventory turnover
This ratio is calculated in times. The rate at which a companys stock is turned over A high stock turnover might mean increased efficiency? But: dependent on the type of business supermarkets might have high stock turnover ratios whereas a shop selling high value musical instruments might have low stock turnover ratio Low stock turnover could mean poor customer satisfaction if people are not buying the goods.

Mary Low

 Average Collection Period = Accounts Receivable Average daily net sales* This ratio is calculated in days. Shorter the better Gives a measure of how long it takes the business to recover debts

Mary Low

Debt Ratios
Long term funds management Measures the riskiness of business in terms of debt 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 in the business (i.e. there is $1.5 of debt to $1 of equity). This higher debt is usually interpreted as bringing in more financial risk for the business particularly if the business has profitability or cash flow problems.

Mary Low

Debt Ratios
Debt/Equity ratio = Long term debt / Total Equity This ratio is calculated in times. Debt/Total Assets ratio = Total Liabilities *100 Total Assets This ratio is calculated in percentage.

Times Interest Earned = Earnings before Interest and Tax Interest

This ratio is calculated in times.

Mary Low

Profitability Ratios
Measures the income or operating success of a company for a given period of time. Profitability measures look at how much profit the firm generates from sales or from its capital assets. All Profitability ratios are calculated in terms of percentage. Gross Profit % = Gross Profit * 100 Net Sales Net Profit % = Net Profit after tax * 100 Net Sales Return on Assets = Return on Equity = Net Profit Total Assets Net Profit Total Equity * 100

*100

Mary Low

Gross Profit Margin Ratio

Gross Profit % = Gross Profit * 100 Net Sales The higher the better Enables the firm to assess the impact of its sales and how much it cost to generate (produce) those sales A gross profit margin of 45% means that for every $1 of sales, the firm makes 45c in gross profit
Mary Low

Return on Equity
Return on Equity = Net Profit Total Equity *100

The higher the better Shows how effective the firm is in using its capital to generate profit A ROE of 25% means that it uses every $1 of capital to generate 25c in profit

Mary Low

Relevant ratios
Profitability ratios: Gross Profit Margin Net Profit Margin Return on Assets Return on Equity Benchmarks 2005 2006

Industry 25% Industry 7% 12%

22%

22.7%

7.1%

6.1%

15.6%

15.5%

Industry 20%

32%

26%

Mary Low

Asset Management ratios: Inventory Turnover Asset Turnover

Benchmarks

2005

2006

Industry 6% 2.0

5.8 times

5.58 times

2.2 times

2.53 times

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Liquidity ratios: Current Ratio

Benchmarks
Ideal standard 2:1 Acceptable standard 1:1

2005 1.78:1

2006 1.70:1

Quick Ratio

Ideal standard 2:1 Acceptable standard 1:1

0.85:1

0.69:1

Mary Low

Financial Structure ratios: Debt/Equity

Benchmarks

2005

2006

Industry 0.6:1 Standard benchmark 1:1 Standard benchmark: 50%

1.05: 1

0.67:1

Debt Ratio

55%

45%

Mary Low

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 companys performance and position is also important to get a better picture of how well the company is actually doing. ROE in 2006 is 26%. this return is certainly more attractive. ROE has decreased by 6% in 2006 but the companys ROE at 26% is still better than the industry average of 20%

Mary Low

 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%.

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

Mary Low

 Liquidity
Current ratios of 1.78:1 (2005) 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 2006 (0.69:1). Raises some concerns over the liquidity of the business and inventory management (although IT ratio only shows a slight decline in 2006).

Mary Low