financial interpretation

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financial interpretation

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Financial Analysis

(E-reading, CloudDeakin)

Objectives

Financial analysis: aim and sources of risk

Assessing performance and risk

Common-size financial statements

Financial ratio analysis

Internal influences

External influences

Sources of information

Limitations

Concluding remarks

Exercises

2

Financial analysis

Aim

profitability, growth and risk management

Product market strategies:

Operating decisions.

Investment decisions.

Financing decisions.

Dividend decisions.

3

Financial analysis

Sources of risk

Business risk

Financial risk

Affected by:

Affected by:

Technology

Competition

Regulation

Consumer taste

Interest rates

Type of funding

Common size financial statements - balance sheet: assets

Steam Ltd

Current assets

Power Ltd

Ind. Ave.

$000

$000

112 118

16.1

83 560

6.8

8.9

Accounts receivable

99 725

14.4

283 861

23.2

13.9

Inventories

12 251

1.8

57 367

4.7

2.1

3 604

0.5

27 477

2.2

10.3

227 698

32.8

452 265

36.9

35.2

67 759

9.8

327 406

26.8

18.9

395 056

57.0

369 732

30.2

42.2

2 682

0.4

75 072

6.1

3.7

465 497

67.2

772 210

63.1

64.8

693 195

100.0

1 224 475

100.0

100.0

Non-current assets

Investments

Land, buildings, plant & equipment

Intangible assets

Total non-current assets

Total assets

5

Common

Size

Balance

Sheet

(Assets)

Common size financial statements - balance sheet: liabilities & equity

Steam Ltd

Current liabilities

Ind.

Ave.

$000

76 855

11.1

234 247

19.1

7.3

123 332

17.8

78 093

6.4

19.6

200 187

28.9

312 340

25.5

26.9

171 055

24.7

573 918

46.9

32.2

Total liabilities

371 242

53.6

886 258

72.4

59.1

Shareholders equity

321 953

46.4

338 217

27.6

40.9

693 195

100.0

100.0

100.0

Accounts payable

$000

Power Ltd

1 224 475

Common

Size

Balance

Sheet

(Liabilities & Equity)

Common size financial statements - profit and loss

Steam Ltd

Power Ltd

Ind. Ave.

$000

$000

639 731

100.0

1 624 341

100.0

100.0

47 378

7.4

40 538

2.5

3.7

493 765

77.2

1 447 113

89.1

85.8

98 588

15.4

136 690

8.4

10.5

Interest expense

15 628

2.4

51 108

3.1

2.8

Tax

33 676

5.3

20 303

1.3

2.6

49 284

7.7

65 279

4.0

5.1

Dividends

16 826

2.6

24 822

1.5

2.0

Sales revenue

Depreciation

Other expenses (incl. COGS)

EBIT

Market data

Market price/share at 30/6/X1

No. of shares (million)

$9.40

$5.14

77.9

195.8

Common

Size

Profit

and

Loss

Financial ratio analysis

Profitability ratios

Measure ability to earn profits steadily over an extended period of time.

Investment ratios

Measure efficiency in management of assets.

Financing ratios

Measure liquidity and solvency in the light of dividend policy.

Measures related to ordinary shares.

8

Financial ratio analysis - Profitability ratios: ROE

Indicates how much a company has earned on funds invested by

ordinary shareholders (i.e., excluding preference shareholders).

Numerator determined by profitability of sales.

Denominator

Financial ratio analysis - Profitability ratios: ROE - example

Power Ltd ROE = 65 279 / 338 217 = 19.3%

Notes:

Financing

Equity, thereby causing an increase in ROE. However, this

comes at greater financial risk.

10

Financial ratio analysis - Profitability ratios: ROA

Indicates how efficient a company has been in earning profits from its assets,

ignoring financing.

return on total funds employed.

11

Financial ratio analysis - Profitability ratios: ROA - example

Notes:

removes effect of interest and tax and focuses on profits from

operating decisions.

12

Financial ratio analysis - Profitability ratios: ROA components

ROA components

Asset

Gross

ROA = Asset Turnover * Gross Profit Margin

13

Financial ratio analysis - Profitability ratios: Asset Turnover - example

Steam Ltd Asset Turnover = 639 731 / 693 195 = 0.92 times

Power Ltd Asset Turnover = 1 624 341 / 1 224 475 = 1.33 times

Notes:

Decisions to buy new equipment, build up inventory levels and

grant credit reduce Asset Turnover.

Decision to run 3 (instead of 1 or 2) shifts per day increases

Asset Turnover.

It is common to use average total assets.

14

Financial ratio analysis - Profitability ratios: Gross Profit Margin - example

Power Ltd Gross Profit Margin = 136 690 / 1 624 341 = 8.4%

Notes:

services.

Indicator of mark-up.

15

Financial ratio analysis - Profitability ratios: Expense ratios

Expense ratios

Measure

Can

cost structure.

16

Financial ratio analysis - Profitability ratios: Depreciation Expense - example

Power Ltd Depreciation Expense = 40 538 / 1 624 341 = 2.5%

Notes:

company could be missing out on a tax shield.

Lower depreciation implies lower cash flow.

17

Financial ratio analysis - Profitability ratios: Interest Expense - example

Power Ltd Interest Expense = 51 108 / 1 624 341 = 3.1%

Notes:

could be missing out on a tax shield.

on the companys capital structure policy.

18

Financial ratio analysis - Investment ratios: Inventory management ratios

Inventory management ratios

Measure

Determined by nature of business: e.g., milk versus cars.

Affected by seasonal factors: e.g., Christmas.

There is a trade-off between high inventory levels and inventory carrying costs.

Build-up of inventory may be indicative of change in consumer taste.

Evaluated using either Inventory Turnover or Inventory Days Outstanding.

Inventory Days Outstanding = (Inventory * 365) / COGS

19

Financial ratio analysis - Investment ratios: Inventory Turnover - example

Power Ltd Inventory Turnover = 1 447 113 / 57 367 = 25.2 times

Notes:

COGS is unavailable.

It is common to use average inventory.

20

Financial ratio analysis - Investment ratios: Inventory Days Outstanding - example

Steam Ltd Inventory Days Outstanding = (12 251 * 365) / 493 765 = 9 days

Power Ltd Inventory Days Outstanding = (57 367 * 365) / 1 447 113 = 14 days

Notes:

COGS is unavailable.

It is common to use average inventory.

21

Financial ratio analysis - Investment ratios: Receivables management ratios

Reflect a companys credit policy particularly its effectiveness in collecting

money from customers.

Affected by economic conditions, industry as well as seasonal factors.

Companies may implement looser credit terms in order to gain market share.

Evaluated using either Receivables Turnover or Average Collection Period.

Average Collection Period = (Receivables * 365) / Credit Sales

22

Financial ratio analysis - Investment ratios: Receivables Turnover - example

Power Ltd Receivables Turnover = 1 624 341 / 283 861 = 5.7 times

Notes:

Calculation

23

Financial ratio analysis - Investment ratios: Average Collection Period - example

Steam Ltd Average Collection Period = (99 725 * 365) / 639 731 = 56 days

Power Ltd Average Collection Period = (283 861 * 365) / 1 624 341 = 63 days

Notes:

Calculation assumes that all sales are credit sales.

Results should be compared with credit terms: e.g, 30 days.

With the use of EFTPOS, the Average Collection Period for

many retailers in Australia is around 3 days.

It is common to use average receivables.

24

Financial ratio analysis - Investment ratios: Payables Days Outstanding

imply that a company is trying to match its Average Collection Period.

25

Financial ratio analysis - Investment ratios: Payables Days Outstanding - example

?

?

Steam Ltd Payables Days Outstanding = (76 855 * 365) / 639 731 = 44 days

Power Ltd Payables Days Outstanding = (234 247 * 365) / 1 624 341 = 52 days

Notes:

the latter are seldom disclosed.

26

Financial ratio analysis - Investment ratios: Cash Cycle

Cash Cycle

Measures how long it takes for inventories to be converted to cash.

As demand grows, inventories, receivables and payables grow. If not

carefully managed, liquidity problems may arise.

27

Financial ratio analysis - Investment ratios: Cash Cycle - example

Power Ltd Operating Cycle = 14 + 63 = 77 days

Cash Cycle = Operating Cycle - Payables Days Outstanding

Steam Ltd Cash Cycle = 65 - 44 = 21 days

X Power Ltd Cash Cycle = 77 - 52 = 25 days

Notes:

It

28

Financial ratio analysis - Financing ratios: general principles

The higher the proportion of assets financed by equity, the lower financial

risk.

However, companies with low levels of debt may be missing out on tax

shields.

At the same time excessive debt is undesirable, particularly when cash flows

are unstable.

Moreover, companies with higher business risk should borrow less.

Furthermore, the nature of the industry affects how much a company can

borrow.

The nature of assets also plays an important role: tangible assets versus

intangible assets.

Financial managers should take all the above into consideration when

determining optimal capital structure (i.e., the level of debt in relation to

equity).

29

Financial ratio analysis - Financing ratios: Debt-to-Assets

Debt-to-Assets

Measures

30

Financial ratio analysis - Financing ratios: Debt-to-Assets - example

Debt-to-Assets = Liabilities / Assets

Power Ltd Debt-to-Assets = 886 258 / 1 224 475 = 72.4%

Notes:

A high Debt-to-Assets ratio is indicative of a high level of

financial risk.

It is common to use average liabilities and assets.

31

Financial ratio analysis - Financing ratios: Debt-to-Equity

Debt-to-Equity

Measures

32

Financial ratio analysis - Financing ratios: Debt-to-Equity - example

Power Ltd Debt-to-Equity = 886 258 / 338 217 = 262%

Notes:

A high Debt-to-Equity ratio is indicative of a high level of

financial risk.

It is common to use average liabilities and shareholders

equity.

33

Financial ratio analysis - Financing ratios: Times Interest Earned

Measures

34

Financial ratio analysis - Financing ratios: Times Interest Earned - example

Power Ltd Times Interest Earned = 136 690 / 51 108 = 2.7 times

Notes:

Companies with stable income can accommodate lower Times

Interest Earned ratios.

Banks like to see Times Interest Earned greater than 3 before

they lend to businesses.

Some analysts use cash flow from operations instead of EBIT.

35

Financial ratio analysis - Financing ratios: Current ratio

Current ratio

Measures the proportion of current assets to current liabilities.

Varies according to type of industry: e.g., manufacturers require higher

current ratio than service providers.

Affected by inventory valuation method.

Indicates safety margin for lenders of short-term funds.

36

Financial ratio analysis - Financing ratios: Current ratio - example

Steam Ltd Current ratio = 227 698 / 200 187 = 1.1 times

Power Ltd Current ratio = 452 265 / 312 340 = 1.4 times

Notes:

If the Current ratio is too high it may be indicative of inefficient

management of working capital.

A Current ratio less than 1 is undesirable.

37

Financial ratio analysis - Financing ratios: Quick ratio

Quick ratio

Measures

Affected by inventory valuation method.

Affected by nature of inventory: whether liquid or not.

Indicates a more stringent safety margin for lenders of short-term funds.

38

Financial ratio analysis - Financing ratios: Quick ratio - example

Steam Ltd Quick ratio = (227 698 - 12 251) / (200 187 - 0) = 1.1 times

Power Ltd Quick ratio = (452 265 - 57 367) / (312 340 - 0) = 1.3 times

Notes:

permanent form of debt.

39

Financial ratio analysis - Market and per share ratios: EPS

Measures

Forward-looking in terms of expected capacity of company to pay dividends.

40

Financial ratio analysis - Market and per share ratios: EPS - example

Notes:

equity.

41

Financial ratio analysis - Market and per share ratios: Earnings Yield

Earnings Yield

Measures

42

Financial ratio analysis - Market and per share ratios: Earnings Yield - example

Power Ltd Earnings Yield = 33.3 / 514 = 6.5%

Notes:

superior, it is only marginally better than that of Power Ltd. For

all practical purposes, the difference is insignificant.

43

Financial ratio analysis - Market and per share ratios: PE

The inverse of Earnings Yield.

Indicates how many times currentearnings investors are willing to pay for a

share.

As such, PE is forward-looking in that it reflects investors perceptions of a

companys earnings potential.

44

Financial ratio analysis - Market and per share ratios: PE - example

Notes:

earnings.

45

Financial ratio analysis - Market and per share ratios: DPS

Measures

46

Financial ratio analysis - Market and per share ratios: DPS - example

Power Ltd DPS = 24 822 / 195 800 = 12.7 cents

Notes:

retain a portion of their profits.

47

Financial ratio analysis - Market and per share ratios: Dividend Yield

Dividend Yield

share, based on its current market price.

48

Financial ratio analysis - Market and per share ratios: Dividend Yield - example

Dividend Yield = DPS / Market Price of a Single Ordinary Share

Notes:

49

Financial ratio analysis - Market and per share ratios: Dividend Payout

Dividend Payout

Measures

50

Financial ratio analysis - Market and per share ratios: Dividend Payout - example

Dividend Payout = Amount of Dividends Paid / NPAT

Notes:

percentage of profit is to be retained.

payout.

51

Financial ratio analysis - Market and per share ratios: Dividend Coverage

Dividend Coverage

basis.

52

Financial ratio analysis -

Power Ltd Dividend Coverage = 33.3 / 12.7 = 2.6 times

Notes:

53

Financial ratio analysis - Market and per share ratios: NAPS

Measures

54

Financial ratio analysis -

Power Ltd NAPS = 338 217 / 195 800 = $1.73

Notes:

Calculation reflects the book value of assets, rather than their

market value.

A relatively high NAPS may be indicative of a potential

takeover.

55

Financial ratio analysis -

Steam Ltd

Power Ltd

Industry

ROE

15.3%

19.3%

15.9%

ROA

14.2%

11.2%

12.1%

0.92 times

1.33 times

0.87 times

15.4%

8.4%

10.5%

Depreciation Expense

7.4%

2.5%

N.A.

Interest Expense

2.4%

3.1%

N.A.

Profitability ratios

Asset Turnover

Gross Profit Margin

56

Financial ratio analysis -

Steam Ltd

Power Ltd

Industry

40.3 times

25.2 times

78 times

9 days

14 days

5 days

6.4 times

5.7 times

8.1 times

56 days

63 days

44 days

44 days

52 days

N.A.

Cash Cycle

21 days

25 days

N.A.

Investment ratios

Inventory Turnover

Inventory Days Outstanding

Receivables Turnover

57

Financial ratio analysis -

Steam Ltd

Power Ltd

Industry

Debt-to-Assets

53.6%

72.4%

59.1%

Debt-to-Equity

115.3%

262%

N.A.

6.3 times

2.7 times

3.7 times

Current ratio

1.1 times

1.4 times

1.3 times

Quick ratio

1.1 times

1.3 times

1.2 times

Financing ratios

58

Financial ratio analysis -

Steam Ltd

Power Ltd

Industry

63.3 cents

33.3 cents

N.A.

6.7%

6.5%

N.A.

PE

14.9 times

15.4 times

N.A.

DPS

21.6 cents

12.7 cents

N.A.

Dividend Yield

2.3%

2.5%

N.A.

Dividend Payout

34%

38%

N.A.

2.9 times

2.6 times

N.A.

$4.13

$1.73

N.A.

EPS

Earnings Yield

Dividend Coverage

NAPS

59

Internal influences

New companies typically have poor liquidity, particularly when they operate in

growth industries.

Seasonal patterns

Inventories typically build up prior to seasonal demand: e.g., Christmas, Easter,

Summer, Winter, etc.

Nature of product

Some products typically have higher turnover than others: e.g., fast food

compared to hardware.

60

External influences

Competition.

Technological

Economic

61

change.

/ political factors.

Sources of information

Other sources include:

Media

The Australian

Analyst

62

reports.

Limitations

inventory.

product line.

up to 15 months late.

63

Limitations - continued

Limitations - continued:

unavailable.

in the Notes to the financial statements.

use averages.

64

Concluding remarks

Do

X Do not

limitations of ratios.

crunching.

categories.

convey similar information.

65

MPA702 in T1 2015

66

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