Financial Statement Analysis

How to Interpret & Analyze Financial Statements

Evaluating Financial Performance

This section provides a clear and concise overview of specific financial ratios used to measure financial performance. Performance areas covered include liquidity, asset management, profitability, leverage, market value ratios, and comparative analysis.
The objective of this section is to provide the user with methodologies that can be useful in measuring and monitoring financial performance.
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Why Ratio Analysis ?

You must measure what you expect to manage and accomplish. Without measurement, you have no reference to work with, and thus, you tend to operate in the dark. One way of establishing references and managing the financial affairs of an organization is to use financial ratios. Ratios are simply relationships between two financial balances or financial calculations. These relationships establish our references so we can understand how well we are performing financially. Ratios also extend our traditional way of measuring financial performance; i.e. relying on financial statements. By applying ratios to a set of financial statements, we can better understand financial performance.
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The Use of Financial Ratios

Ratio analysis is used to compare a company's performance and status with that of another company or itself over time. The basic inputs to ratio analysis is items from Income statement and Balance Sheet Whats important in ratio analysis is the interpretation, rather than the calculation itself.

We should Consider the following

A single ratio does not generally provide sufficient information from which to judge the overall performance of the firm. A group of ratios should be used The financial statements being compared should be dated at the same point in time during the year. To avoid the effect of seasonality. Use audited financial statements. Compare financial statements with similar accounting treatments.
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Types of Ratio Comparison

Cross Sectional The comparison of different Companies financial ratios at the same point in time; involves comparing the companys ratios to those of an industry leader or to the industry average. Times series Evaluation of the companys financial performance over time utilizing financial ratio analysis Combined analysis
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Dollar and Percentage Changes

Dollar Change:
Dollar Change

Analysis Period Amount

Base Period Amount

Percentage Change:
Percent Change

Dollar Change

Base Period Amount

Dollar and Percentage Changes

Lets look at the asset section of Clover, Inc. comparative balance sheet and income statement for 2007 and 2006. Compute the dollar change and the percentage change for cash.

Clover, Inc. Comparative Balance Sheets December 31, 2007 Assets Current assets: Cash and equivalents $ 12,000 Accounts receivable, net 60,000 Inventory 80,000 Prepaid expenses 3,000 Total current assets $ 155,000 Property and equipment: Land 40,000 Buildings and equipment, net 120,000 Total property and equipment $ 160,000 Total assets $ 315,000 * Percent rounded to one decimal point. 2006 Dollar Change Percent Change*

$ 23,500 40,000 100,000 1,200 $ 164,700 40,000 85,000 $ 125,000 $ 289,700

Clover, Inc. Comparative Balance Sheets December 31, 2007 2006 Dollar Change Percent Change*

Assets Current assets: Cash and equivalents $ 12,000 $ 23,500 $ (11,500) Accounts receivable, net 60,000 40,000 Inventory 80,000 100,000 Prepaid expenses 3,000 1,200 $12,000 Total current assets $ 155,000 $23,500 $ 164,700= $(11,500) Property and equipment: Land 40,000 40,000 Buildings and equipment, net 120,000 85,000 Total property and equipment $ 160,000 $ 125,000 Total assets $ 315,000 $ 289,700 * Percent rounded to one decimal point.

Clover, Inc. Comparative Balance Sheets December 31, 2007 2006 Dollar Change Percent Change*

Assets Current assets: Cash and equivalents $ 12,000 $ 23,500 $ (11,500) -48.9% Accounts receivable, net 60,000 40,000 Inventory 80,000 100,000 Prepaid expenses 3,000 1,200 ($11,500 $23,500) 100% = 48.94% Total current assets $ 155,000 $ 164,700 Property and equipment: Complete the Land 40,000 40,000 analysis for the Buildings and equipment, net 120,000 85,000 other assets. Total property and equipment $ 160,000 $ 125,000 Total assets $ 315,000 $ 289,700 * Percent rounded to one decimal point.

Clover, Inc. Comparative Balance Sheets December 31, 2007 Assets Current assets: Cash and equivalents $ 12,000 Accounts receivable, net 60,000 Inventory 80,000 Prepaid expenses 3,000 Total current assets $ 155,000 Property and equipment: Land 40,000 Buildings and equipment, net 120,000 Total property and equipment $ 160,000 Total assets $ 315,000 * Percent rounded to one decimal point. 2006 Dollar Change Percent Change*

$ 23,500 $ 40,000 100,000 1,200 $ 164,700 40,000 85,000 $ 125,000 $ 289,700 $

(11,500) 20,000 (20,000) 1,800 (9,700) 35,000 35,000 25,300

-48.9% 50.0% -20.0% 150.0% -5.9% 0.0% 41.2% 28.0% 8.7%

Trend Percentages

Trend analysis is used to reveal patterns in data covering successive periods.

Trend Percentages

Analysis Period Amount Base Period Amount

100%

Trend Percentages
Berry Products Income Information For the Years Ended December 31,

Item Revenues Cost of sales Gross profit

2007 $ 400,000 285,000 115,000

2006 $ 355,000 250,000 105,000

2005 $ 320,000 225,000 95,000

2004 $ 290,000 198,000 92,000

2003 $ 275,000 190,000 85,000

Item Revenues Cost of sales Gross profit

2007 2006 2005 2004 145% 129% 116% 105% 2003 is the base period so 150% 132% 118% 104% its amounts equal 108% 135% 124% will 112%

(290,000 275,000) (198,000 190,000) (92,000 85,000)

100%. 100% = 105% 100% = 104% 100% = 108%

2003 100% 100% 100%

Component Percentages
Examine the relative size of each item in the financial statements by computing component (or common-sized) percentages.
Component Percentage

Analysis Amount Base Amount

100%

Financial Statement Balance Sheet Income Statement

Base Amount Total Assets Revenues

Clover, inc. Comparative Balance Sheets December 31,

Complete the common-size analysis for the other assets.

2007 2006

Common-size Percents* 2007 2006

Assets Current assets: Cash and equivalents $ 12,000 $ 23,500 3.8% 8.1% Accounts receivable, net 60,000 40,000 Inventory 80,000 100,000 Prepaid expenses 3,000 1,200 ($12,000 $315,000) 100% = 3.8% Total current assets $ 155,000 $ 164,700 Property and equipment: ($23,500 $289,700) 100% = 8.1% Land 40,000 40,000 Buildings and equipment, net 120,000 85,000 Total property and equipment $ 160,000 $ 125,000 Total assets $ 315,000 $ 289,700 100.0% 100.0% * Percent rounded to first decimal point.

Clover, Inc. Comparative Balance Sheets December 31, Common-size Percents* 2007 2006

2007 Assets Current assets: Cash and equivalents $ 12,000 Accounts receivable, net 60,000 Inventory 80,000 Prepaid expenses 3,000 Total current assets $ 155,000 Property and equipment: Land 40,000 Buildings and equipment, net 120,000 Total property and equipment $ 160,000 Total assets $ 315,000 * Percent rounded to first decimal point.

2006

$ 23,500 40,000 100,000 1,200 $ 164,700 40,000 85,000 $ 125,000 $ 289,700

3.8% 19.0% 25.4% 1.0% 49.2% 12.7% 38.1% 50.8% 100.0%

8.1% 13.8% 34.6% 0.4% 56.9% 13.8% 29.3% 43.1% 100.0%

Clover, Inc. Comparative Balance Sheets December 31, Common-size Percents* 2007 2006

2007 Liabilities and Shareholders' Equity Current liabilities: Accounts payable Notes payable Total current liabilities Long-term liabilities: Bonds payable, 8% Total liabilities Shareholders' equity: Preferred stock Common stock Additional paid-in capital Total paid-in capital Retained earnings Total shareholders' equity Total liabilities and shareholders' equity * Percent rounded to first decimal point.

2006

$ 67,000 $ 44,000 3,000 6,000 $ 70,000 $ 50,000 75,000 $ 145,000 80,000 $ 130,000

21.3% 1.0% 22.3% 23.8% 46.1% 6.3% 19.0% 3.2% 28.5% 25.4% 53.9% 100.0%

15.2% 2.1% 17.3% 27.6% 44.9% 6.9% 20.7% 3.5% 31.1% 24.0% 55.1% 100.0%

20,000 20,000 60,000 60,000 10,000 10,000 $ 90,000 $ 90,000 80,000 69,700 $ 170,000 $ 159,700 $ 315,000 $ 289,700

Clover, Inc. Comparative Income Statements For the Years Ended December 31, Common-size Percents* 2007 2006 2007 2006 Revenues $ 520,000 $ 480,000 100.0% 100.0% Costs and expenses: Cost of sales 360,000 315,000 69.2% 65.6% Selling and admin. 128,600 126,000 24.7% 26.3% Interest expense 6,400 7,000 1.2% 1.5% Income before taxes $ 25,000 $ 32,000 4.8% 6.7% Income taxes (30%) 7,500 9,600 1.4% 2.0% Net income $ 17,500 $ 22,400 3.4% 4.7% Net income per share $ 0.79 $ 1.01 Avg. # common shares 22,200 22,200 * Rounded to first decimal point.

Common Size Analysis (Income Statement)

Item Description Total Sales Less: Cost of Goods Sold Gross Profit Less: Selling, General & Administrative Expenses Less: Depreciation Operating Profit Add: Interest Income Add: Investment Income Add: Other Sundry Income Less: Other Sundry expense Earnings Before Interest & Tax (EBIT) Less: Interest Expenses Earnings Before Tax (EBT) Less: Tax Net Profit After Taxes 2003 500 350 150 70 8 72 10 10 15 77 40 37 8 29 2004 550 360 190 75 10 105 11 15 20 111 38 73 15 58 Commom Size (Vertical) 2003 2004 100% 100% 70% 65% 30% 35% 14% 2% 14% 2% 0% 2% 3% 15% 8% 7% 2% 6% 14% 2% 19% 2% 0% 3% 4% 20% 7% 13% 3% 11% Horizontal Analysis 2003 2004 100% 110% 100% 103% 100% 127% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 107% 125% 146% 110% 150% 133% 144% 95% 197% 188% 200%
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Common Size Analysis (Balance Sheet)

As s e ts Cash Accounts Receivables Inventory Total Curre nt As s e ts Land Buildings Machinery Other Fixed Assets (Accumulated Depreciation) Ne t Fixe d As s e ts TOTAL ASSETS Liabilitie s & Equity Short Term Debt Accounts Payable Accrued Expenses Total Curre nt Liabilitie s Long Term Debt Total Liabilite s Common Stock Reserves Retained Earnings Total Equity Total Liabilitie s & Equity 2003 100 150 200 450 50 120 300 90 55 505 955 2003 95 120 60 275 250 525 200 150 80 430 955 2004 110 165 210 485 50 125 320 95 65 525 1,010 2004 120 130 65 315 225 540 200 165 105 470 1,010 Commom Size (Vertical) 2003 2004 10% 11% 16% 16% 21% 21% 47% 48% 5% 13% 31% 9% 6% 53% 100% 2003 10% 13% 6% 29% 26% 55% 21% 16% 8% 45% 100% 5% 12% 32% 9% 6% 52% 100% 2004 12% 13% 6% 31% 22% 53% 20% 16% 10% 47% 100% Horizontal Analysis 2003 2004 100% 110% 100% 110% 100% 105% 100% 108% 100% 100% 100% 100% 100% 100% 100% 2003 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 104% 107% 106% 118% 104% 106% 2004 126% 108% 108% 115% 90% 103% 100% 110% 131% 109% 106%

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Main Groups of Financial Ratios

Analyzing Liquidity Analyzing Activity (Asset Management) Analyzing Debt Analyzing Profitability

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Analyzing Liquidity

The liquidity of a business firm is measured by its ability to satisfy its short-term obligations as they come due. Current Ratio Quick (Acid-Test) Ratio Cash Ratio. Net Working Capital

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Analyzing Liquidity: Current Ratio

It is a measure of liquidity calculated by dividing the firms current assets by its current liabilities

Current Ratio = Current Assets / Current Liabilities

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Analyzing Liquidity: Quick (Acid-test) Ratio

It is similar to the current ratio; except it excludes the inventory; which is generally the least liquid current asset.

Quick Ratio = (Current assets Inventory) / Current Liabilities

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Analyzing Liquidity: Net Working Capital

A measure of liquidity calculated by subtracting current liabilities from current assets

Net Working Capital = Current Assets Current Liabilities It is only useful for internal control inside the company, not for comparison with other companies

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Liquidity Measures

Note that for all three liquidity measures; the higher the value, the more liquid the firm is typically considered to be. However this low risk sacrifices profitability Current assets are less profitable/productive than fixed assets Current liabilities are a less expensive financing source than long term funding

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Asset Management

Activity ratios are used to measure the speed in which various accounts are converted into sales or cash. Inventory Turnover Average Collection Period Average Payment Period Fixed Asset Turnover Total Assets Turnover

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Asset Management: Inventory Turnover

It measures the activity or liquidity of a firms inventory Inventory Turnover = COGS / Inventory

Inventory Days on Hand It is the average length of time inventory is held by the firm Inventory Days on Hand = 365 / Inventory Turnover

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Asset Management: Average Collection Period

It is the average amount of time needed to collect accounts receivable

Accounts Receivable Turnover = Sales / Accounts Receivable Average Collection Period (Days Sales Outstanding) = 365 / A/R Turnover

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Asset Management: Average payment Period

It is the average amount of time needed to pay accounts payable

Accounts Payable Turnover = COGS / Accounts Payable Average Payment Period = 365 / A/P Turnover

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Asset Management: Fixed Assets Turnover

It measures the efficiency with which the firm has been using its fixed or earning, assets to generate sales

Fixed Assets Turnover = Sales / Net Fixed Assets

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Asset Management: Total Assets Turnover

It indicates the efficiency with which the firm uses all its assets to generate sales

Total Assets Turnover = Sales / Total Assets

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Analyzing Debt

The debt position of a firm indicates the amount of other peoples money being used in attempting to generate profits. Generally, the more debt a firm uses in relation to its total assets, the greater its financial leverage.

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Analyzing Debt: Debt Ratio

It measures the proportion of total assets financed by the firms creditors

Debt Ratio = Total Liabilities / Total Assets

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Analyzing Debt: Debt-Equity ratio

It measures the ratio of long-term debt to stockholders equity

Debt-Equity Ratio = Long-Term Debt/Equity

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Analyzing Debt: Times Interest Earned

It measures the firms ability to make contractual interest payments

Times Interest Earned= Earnings Before Tax / Interest Expense

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Analyzing Profitability

Gross Profit Margin Operating Profit Margin Net Profit Margin Return on Assets Return on Equity Earning Per Share (EPS) Price/Earnings Ratio (P/E ratio)

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Gross Profit Margin

It measures the percentage of each sales dollar remaining after the firm paid for its goods

Gross Profit Margin = (Sales-COGS) / Sales

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Operating Profit Margin

It measures the percentage of profit earned on each sales dollar before interest and taxes

Operating Profit Margin= Operating Profit / Sales

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Net Profit Margin

It measures the percentage of each sales dollar remaining after all expenses, including taxes, have been deducted

Net Profit Margin= Net Profit after Taxes / Sales

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Return on Total Assets

It measures the overall effectiveness of management in generating profits with its available assets.

Return on Total Assets=Net Profit after Tax/ Total Assets

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Return on Assets (ROA)

It measures the efficiency with which a company allocates and manages its resources. there are tow determinants for controlling REA :

Net Income Net income ROA = -------------- = ---------------Assets sales

ROA =

sales ------------assets
assets turnover

Profit margin X

Return on Equity

It measures the return earned on the owners (both preferred and common stockholders) investment n the firm

Return on Equity = Net Profit after Tax / Stockholders Equity

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Return on Equity

There are three determinants for controlling REO :

Profit Margin.

Asset Turnover.
Financial Leverage.

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Return on Equity

It measures the return earned on the owners (both preferred and common stockholders) investment n the firm Return on Equity = Net income/ Stockholders Equity
Net income ROE = __________ sales Sales X ___________ Assets Assets X __________________ (Shareholder's equity) X Financial Leverage

ROE = Profits Margin X Assets Turnover

Is ROE a reliable Financial Yardstick?

The Timing Problem. The Risk Problem. The value problem.

The timing Problem

Because ROE necessarily includes only one years earning, it fails to capture the full impact of multiperiod decision.

The risk Problem

ROE say nothing about what risks a company has taken to generate it.

The value Problem

The market value of equity is more significant to shareholders because it measures the current, realizable worth of the share, while book value is only history.

Earnings per Share

It represents the number of dollars earned on behalf of each outstanding share of common stock.

EPS=Earnings Available for Common Stockholders / Number of Shares of Common Stocks Outstanding

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Price/Earnings Ratio

It reflects the amount investors are willing to pay for each dollar of the firms earnings; the higher the P/E ratio, the greater the investor confidence in the firm

P/E Ratio=Market Price per Share of Common Stocks/ Earnings Per Share

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Questions & Answers