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TOOLS OF FINANCIAL TOOLS OF FINANCIAL STATEMENT ANALYSISSTATEMENT ANALYSIS
BY H ONDIGO
SCHOOL OF BUSINESSUNIVERSITY OF NAIROBI
2012
Presentation Objectives1. Explain business analysis and its relation
to financial statement analysis
2. Identify and discuss different types of business analysis
3. Describe the component analysis
4. Learn the sources of financial information
5. Identify and describe the common tools of Financial analysis
6. Define EMH and State implications for Analysis
2
ProspectiveAnalysis
AccountingAnalysis
BusinessEnvironment &
Strategy Analysis
IndustryAnalysis
StrategyAnalysis
FinancialAnalysis
Analysisof Sources&Uses of
FundsProfitability
Analysis
RiskAnalysis
Cost of Capital Estimate Intrinsic Value
Business Analysis
Business analysis is the evaluation of a company’s prospects & risks for the purpose of making business decision
4
Business Decision Makers include:•Equity Investors•Creditors•Managers •Merger and Acquisition Analysis•External Auditors•Directors•Regulators•Employees and Unions
Accounting Analysis
Comparability problems — across firms and across time
Manager estimation error
Distortion problems Earnings management
Distortion of business
AccountingRisk
Process to evaluate and adjust financial statements to better reflect economic reality
Strategy Analysis
The purpose of Business Strategy Analysis Identify key profit drives and business risks Assess company’s profit potential at a
qualitative level• Strategy Analysis involves Industry analysis Competitive strategy Corporate strategy analysis
6
Industry Analysis
Analyzing a firm’s profit potential must first assess industry profitability. It includes:
• Degree of actual and potential competition (1) Rivalry among existing firms (2) Threat of new entrants (3) Threat of substitute products• Bargaining power in input and output markets (1) Bargaining power of buyers (2) Bargaining power of suppliers
7
Competitive strategy analysis
Competitive strategy analysis is the evaluation of a company’s decisions and success at establishing a competitive advantages
• Cost leadership: supply same product and service at the lower cost
• Differentiation: supply a unique product or service at a cost lower than the price premium customers will pay
8
Corporate strategy analysis
• Involves examining whether a company is able to create value in multiple businesses
• A well-crafted corporate strategy reduces costs or increase revenues from running several businesses in one firm.
• Cost saving or revenue increases come from specialized resources that the firm has to exploit synergies across these businesses
9
Financial (Statement) Analysis
Financial statement analysis is the process of analyzing financial information to predict the future financial performance and condition
An important part of business analysisProvide a systematic and effective statement
analysisReliable inferences are drawn about a company
prospects and risks
10
Financial (Statement) Analysis
Profitability analysis — Evaluate return on investments
Risk analysis ——— Evaluate riskiness & creditworthiness
Sources and uses —Evaluate source & of funds analysis deployment of funds
Common tools
Ratioanalysis
Cash flow
analysis
Process to evaluate financial position and performance using financial statements
Prospective Analysis
Intrinsic Value
Business Environment& Strategy Analysis
Accounting Analysis
Financial Analysis
Process to forecast future payoffs
Sources of Financial Information
Principle financial statements include:– The Statement of financial Position (balance sheet)
– The statement of income– The statement of cash flow– The statement of stockholders’ equity
Notes to the financial statements Auditor’s report Management discussion and analysis Other data sources: Chairperson’s letter, Finance press, Web sites, Industry
statistics, Economic indicators
• . 13
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.
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.
Financial Statement AnalysisPurpose: 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:
– Intra-company 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.
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
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.
Effective Financial Statement AnalysisRequires 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
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
Cash Flow Analysis Valuation
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
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
Profitability Ratios Gross Profit % = Gross Profit * 100
Net Sales Net Profit % = Net Profit after tax * 100
Net SalesOr 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 *100Average Total Equity
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.
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
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
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
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.
Financial Structure or Capitalisation Ratios
Debt/Equity ratio = Debt / Equity
Debt/Total Assets ratio = Debt *100Total Assets
Equity ratio = Equity *100Total Assets
Times Interest Earned = Earnings before Interest and TaxInterest
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.
Market Test Ratios
Earnings per share = Net Profit after taxNumber 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
Illustration: Financial statement analysis
The following financial statements of Hifadhi Ltd were prepared in accordance with IFRSs. Hifadhi Ltd is a diversified enterprise with its main interests in the manufacture and retail of plastic products.
The financial statements of Hifadhi 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
Hifadhi Ltd Statement of Financial Position as at 31 March
2011 2012 Horizontal Analysis
$000 $000 $000 $000 Current Assets Bank 33.5 41.0 Accounts receivable 240.8 210.2 Inventory 300.0 370.8 574.3 622.0 108 Non-current assets Fixtures & fittings (net) 64.6 63.2 Land & buildings (net) 381.2 376.2 445.8 439.4 99 Total assets 1,020.1 1,061.4 104 Current Liabilities
Accounts payable 261.6 288.8 Income tax 60.2 76.0 321.8 364.8 113 Non-current liabilities Loan 200.0 60.0 30 Shareholders Funds
Paid-up ordinary capital 300.0 334.1 Retained profit 198.3 302.5 498.3 636.6 128 Total liabilities & equity 1,020.1 1,061.4 104
Hifadhi LtdStatement of Financial Performance for year ended 31 March
2011 2012 Horizontal Analysis
$000 $000 $000 $000 Sales 2,240.8 2,681.2 120 Less Cost of goods sold 1,745.4 2,072.0 119 Gross profit 495.4 609.2 123 Wages & salaries 185.8 275.6 Rates 12.2 12.4 Heat & light 8.4 13.6 Insurance 4.6 7.0 Interest expense 24.0 6.2 Postage & telephone 9.0 16.4 Depreciation - Buildings 5.0 5.0 Fixtures & fittings 27.0 276.0 32.8 369.0 134 Net profit before tax
219.4
240.2 109
Less Income tax 60.2 76.0 126 Net profit after tax 159.2 164.2 103
Hifadhi LtdStatement of Cash Flows for the year ended 31 March
2011 2012 $000 $000 $000 $000 Cash flow from operations Receipts from customers 2,281 2,711.8 Payments to suppliers & employees (2,050) (2,460.4) Interest paid (24) (6.2) Tax paid (46.4) (60.2) Net cash flow from operating activities 160.6 185 Investing activities Purchase of non-current assets (121.2) (31.4) Net cash used in investing activities (121.2) (31.4) Financing activities Dividends paid (32.0) (40.2) Issue of ordinary shares 20.0 34.1 Repayment of loan capital -__ (140.0) Net cash outflow from financing activities (12) (146.1) Increase in cash & cash equivalents 27.4 7.5
Additional information:
Credit purchases for the year 2012 were $2,142,800.General prospects for the major industries in which
Hifadhi 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 Hifadhi Ltd because
it is a diversified company. The following are average indicators that relate to the plastic retailing and manufacturing industries for the year 2012. 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%
Relevant ratios
Profitability ratios:
Benchmarks 2011 2012
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%
Important note: The calculations of the ratios in this illustration did not use “averages” for total assets, equity and inventory. The 2011 and 2012 year end figures were used and this is a slight variation to the formulas provided.
Relevant ratios cont…
Asset Management
ratios:
Benchmarks 2011 2012
Inventory Turnover
Industry
6 %
5.8 times 5.58 times
Asset Turnover
Not given 2.2 2.53
Relevant ratios cont…
Liquidity ratios:
Benchmarks 2011 2012
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
Relevant ratios cont…Financial Structure
ratios:
Benchmarks 2011 2012
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
The 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 2012 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 2012.
The Report cont…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 unfavorable 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 ManagementIT 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
The Report cont…
Liquidity– Current ratios of 1.78:1 (2011) 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 2012 (0.69:1).
– Raises some concerns over the liquidity of the business and inventory management (although IT ratio only shows a slight decline in 2012).
– Days Payable is a concern as there may be poor debt payment management.
The Report cont…
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 2012.
– 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.
Recommendation
Given:1) The strong forecast for the industry (ie general
prospects looking good and world demand for plastic products remaining strong),
2) The sales growth in this business, 3) Acceptable ratios as they are quite close to the
industry averages, 4) Good cash flows from operating activities and 5) 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 Hifadhi Ltd company.
Comparative/Horizontal Financial Statement AnalysisThis involves reviewing consecutive financial
statements from period to period.It usually involves a review of changes in individual
account balances on a year to year or a multi year basis.
The most important information revealed by the analysis is the trend.
For example a 10% increase in sales accompanied by a 20 % in cost of sales or selling expenses may require investigation and explanation. Similarly a 30% increase in receivables accompanied by a sales increase of 10% calls for investigation.
Two comparative analysis techniques include: Year to year change analysis Index number/ Trend analysis
Trend (percentage) analysis
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.
Comparative Analysis
Purpose: Evaluation of consecutive financial statements
Output: Direction, speed, & extent of any trend(s)
Types: Year-to-year Change Analysis
Index-Number Trend Analysis
Yr2Yr1 Yr3
Analysis Preview
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Extract of Trend Analysis of Kodak
0.7000.7500.8000.8500.9000.9501.0001.050
1997 1998 1999 2000 2001
Ind
ex -
Bas
e 19
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Kodak's Index-Number Trends - Sales and Operating expenses (1997 = base year)
Sales
Operating expenses
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
Common-Size Analysis
Purpose : Evaluation of internal makeup of financial statements
Evaluation of financial statement accounts across companies
Output: Proportionate size of assets, liabilities, equity, revenues, & expenses
2-53
Common-Size Analysis
2-54
Common-Size Analysis
Cash Flow Analysis This is primarily a tool used to evaluate the sources
and uses of funds. It provides insights into how a company is obtaining its financing and deploying its resources, It is used in cash flow forecasting as part of liquidity analysis
While a simple analysis of the statement of cash flows conveys much information about sources and uses of funds, it is important to analyze statement of cash flows in more detail to understand the composition and implications of statement of cash flows along with the knowledge of the company’s business environment and strategies
Valuation Is an important outcome of many types of
business and financial statement analysis It refers to the estimation of the true/intrinsic/
theoretical value of a company or a security (Debt or Bond).
The basis of valuation is the present value theory, which states that the value of equity or debt security (or any asset for that matter) is the sum of all future payoffs from that security that are discounted to the present at an appropriate discount rate.
It uses the time value of money concept.
Bond Valuation
As stated earlier, the value of a security is the present value of its future payoffs discounted at an appropriate discount rate.
The future payoffs from a debt security are its interest and principal payments.
A bond contract specifies its future payoffs along with the investment horizon.
The value of a bond (B) at time t , Bt is given by the following formula/model:
Debt (Bond) Valuation
Bt = It +1 + It +2 + It +3 + ... + It +n + F
(1+r)1 (1+r)2 (1+r)3 (1+r)n (1+r)n
Where, Bt is the value of the bond at time tIt +n is the interest payment in period t+nF is the principal payment (usually the debt’s face value)r is the interest rate (yield to maturity)
Equity Valuation The basis of equity valuation, like debt valuation, is the
present value of future payoffs discounted at an appropriate discount rate
Equity valuation is however more complex than debt valuation ,this is because the future payoffs are predetermined, with equity the investor has no predetermined payoffs
Investors in equity looks for two main (uncertain) payoffs:
– Dividends payments
– Capital appreciations (gains)
Equity Valuation – Dividend model
Capital gains are determined by future dividends therefore the value of an equity security ,Vt, at time t equals to the sum of the present values of all future
dividends expected as per the model below:Vt = E(Dt +1) + E(Dt +2) + E(Dt +3) + ... + E(Dt +n)
+ ...
(1+k)1 (1+k)2 (1+k)3 (1+k)n
Where:Vt is the value of an equity security at time tDt +n is the dividend in period t+nk is the cost of capitalE() refers to expected dividends
Equity Valuation - Free Cash Flow Model An alternative to dividend valuation is the present
value of future cash flows- free cash flows (FCF) FCF are cash flows that at are free to be paid to
investors which are appropriate measure of equity payoffs
Where:FCFt+n - is the free cash flow in the period t + n [often
defined as cash flow from operations less capital expenditures]k - is the cost of capitalE(•) refers to an expectation
Vt = E(FCFt +1) + E(FCFt +2) + E(FCFt +3) + ... + E(FCFt +n)
+ ... (1+k)1 (1+k)2 (1+k)3 (1+k)n
Equity Valuation - Residual Income ModelEquity Valuation - Residual Income ModelThe model uses accounting variables.It defines the value of equity at time t is the
sum of current book value and the present value of all future expected residual income
Where:Rit+n is the residual income in period t + n [defined as net income, NI, minus a charge on beginning book value, BV, or RIt = NIt - (k x BVt-1)] k is the cost of capital E(•) refers to an expectation
Vt = BVt + E(RIt +1) + E(RIt +2) + E(RIt +3) + ... + E(RIt +n) + ... (1+k)1 (1+k)2 (1+k)3 (1+k)n
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.
Analysis in an Efficient Market The efficient market hypothesis (EMH),
deals with the reaction of market prices to financial or other information
The weak form asserts that prices reflect fully the information contained in historical price movements
The semi strong form asserts that prices reflect fully all publicly available information
The semi form asserts that prices reflect all information including inside information
Efficient Market Hypothesis There are considerable research on EMH. Early evidence strongly supported both the weak
and semi strong form of EMH in developed and emerging markets.
More recent research (in behavioral finance) question the generality of the EMH
A number of stock anomalies have been uncovered suggesting investors can earn excess returns using simple trading strategies
However as an approximation, the current market price is a reasonable estimate of equity value
Market Efficiency and Analysis
Market Efficiency • Assumes competent and informed analysts
using the tools of analysis described • Assumes analyst are continuously evaluating
and acting on the stream of information entering the market place
• Extreme proponents of EMH claim that if all the information is instantly reflected in prices then attemptds to reap abnormal returns through analysis is futile.
• However if analyts presume their efforts in analysis are futile, the efficiency of the market ceases.
• This presents the EMH paradox
The EMH paradox EMH is based on the aggregate rather than individual
investor behavior- focusing on the aggregate behavior averages performances
Market efficiency depends not only on the availability of information but also on its correct interpretation. Analysis is complex and demanding
A competent analysis of information entering into the market place requires sound analytical knowledge and information mosaic- knowing information to aid evaluation and interpretation.
Warren Buffet expresses amazement that EMH is still embraced by some scholars and analysts.
According to Buffet by observing correctly that the market is frequently efficient, some scholars conclude incorrectly that it is always efficient.
67
Course Presentation OrganizationFinancial Reporting & Analysis
Part IIntroduction and Overview
Part IIIFinancial Analysis
Part IIAccounting Analysis
1: Overview of Financial Analysis2: Financial Reporting and Analysis
3: Analyzing Financial Activities 4: Analyzing Investing Activities 5: Analyzing Investing Activities: Special topic 6: Analyzing Operating Activities
7: Cash Flow Analysis 8: Return on Invested Capital 9: Profitability Analysis10: Prospective Analysis11: Credit Analysis12: Equity Analysis and Valuation
END OF PRESENTATION
THANK YOU
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