Chapter 14 Analyzing Financial Statements

N.B: This is a very Important Chapter Ignore the following Slides from "Chapter 14

Presentation" Not taken in 9th financial lecture - :

Slides From 5 To 6 Slides # 27 Slides From 46 To 48 Investment Decision Issues:

In considering an investment decision in the stock of a corporation, potential investors should evaluate the companys future income and growth potential on the basis of industry factors and economy-wide factors as well as individual company factors.

Importatnt Investment Factors: Economy Factors "Macro Level Thinking" (Such as: political stability,etc)

Industry Factors "Micro Level Thinking"(Such as: raw material existence, trained labors, demand vs. supply, competitionsetc)

Companys Factors (Such as: companys financial statements , companies future earnings and stock prices.etc)

Return on an equity investment:

Earning dividends (Long-Term Investment)

Increase in share price (Short-Term Investment)

Three types of financial statement information: Past Performance (Such as: Income, sales volume, cash flows, return- on-investments, EPS..etc)
1. 2

Present Condition (Such as: Assets, debt, inventory, various ratios ..etc)
2.

Future Performance (Such as: Sales and earnings trends are good indicators of future performance ..etc) Financial Statement Analysis Financial statement analysis is based on comparisons 1. Comparison with similar companies or major competitors (Cross Sectional analysis) 2. Comparison with industry average 3. Comparison with previous years for single company to identify trends over time (Time series analysis)
3.

Tools of Financial Statement Analysis

1. 2. 3.

Horizontal Analysis (Trend Analysis) Vertical Analysis (Component Percentages) Ratio and Percentage Analysis Horizontal Analysis

It is a comparison of the same company with previous year only to identify trends over time - Change in amount = current (recent) year amount base (oldest) year amount - Change in precentage = Change in amount / base (oldest) year Net Sales 2009 2008 $ 200,000 $ 160,000 Change Amount precentage $ 40,000 25 %

Trend Analysis (Gross Rate)

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It is a special case of Horizontal Analysis by comparing company's values with previous years (5 or 6 years) to identify trends over time. We take oldest year amount as a base (100%) and dividing each year over the base to get gross presentage as shown in this example (Comparison of Net Sales from 2004 to 2009) 2009 2008 2007 2006 2005 2004 $ $ $ $ $ $ 200,000 160,000 152,000 145,000 130,000 120,000

167 %

133 % 127 % 121 % 108 % 100 % For the previous Trend Analysis (Net Sales from The Gross Rate in 2004 - 2009) ,we can draw Sales between 2004 & results to gross percentage identify trends over time graphically
180% 160% 140% 120% 100% 80% 60% 40% 20% 0% 167% 133% 127% 121% 108% 100%

2009

2008

2007

2006

2005

2004

Applying Trend Analysis on 1st Example Net Sales Change 2009 2008 Amount precentage $ 200,000 $ 160,000 $ 40,000 25 % 125% 100%

Vertical Analysis (Component Percentages) Express each item on a particular statement as a percentage of a single base amount.

On the income statement, the base amount is Net Sales

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On the balance sheet, the base amount is Total Assets Vertical analysis of the income statement expresses each item as a percentage of the net sales figure. In each column the net sales figure is used as the base, or 100 percent. Every amount in the column is expressed as a percentage of net sales. To compute an items percentage of net sales, divide the amount of that item by the amount of net sales. Example, the income statement for the month ended 31/3/ 2007:

As we discussed before:

Given that: cost of goods sold = $ 270,000 & Net Sales = $ 400,000
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The percentage of COGS per Sales is = (COGS / Net sales) *100 % = 67.5 % Gross Profit Margin= (Gross Profit / Net sales) *100 % = 32.5 % Profit Margin (ROS)= (Net Income / Net sales) *100 % = 7.25 %
Vertical Analysis

100 % 67.5 % 32.5 % 15.5 % 2.75 % 0.25 % 20.6 % 12 % 0.3 % 0.25 % 0.55 % 0.06 % 12 % 4.75 % 7.25 %

Ratio and Percentage Analysis

Summary of all ratios taken in "Accounting & Financial" course

Solvency Ratios (Long-Run Tests): 1. Debt Ratio (D2A) = (Total Liabilities / Total Assets) X 100%
2.

Debt to Equity Ratio (D2E) = (Total Liabilities / Stockholders' Equity) X 100% Financial Leverage or Leverage Multiplier = Total Assets / Stockholders' Equity

3.

Liquidity Ratios (Short-Run Tests): 1. Current Ratio = Current Assets / Current Liabilities
2.

Quick Ratio (ACID Test) = Quick Assets / Current Liabilities = (Cash & Cash Equivalent + Marketable Securities + Account Receivable) / Current Liabilities

3. 4.

Cash Ratio = Cash & Cash Equivalent / Current Liabilities Working Capital = Current Assets Current Liabilities

Profitability Ratios: 1. Return on Sales (ROS) or Net Profit Margin = (Net Income / Net Sales) X 100%
2.

Return on Equity (ROE) = (Net Income / Average Owners' Equity) X 100% Return on Assets (ROA) = (Net Income / Average Total Assets) X 100% Gross Profit Margin (GPM) = (Gross Profit / Net Sales) X 100% Earnings Per Share (EPS) = Net Income / No. Of Shares
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3.

4.

5.

 ROE Profit Driver Analysis:

ROE

Net Profit Net Profit Margin (ROS) Margin (ROS)

Asset Asset Turnover Turnover

Financial Financial Leverage Leverage

Efficiency (Assets Management) Ratios: 1. Total Assets Turnover = Net Sales / Average Total Assets
2.

Fixed Assets Turnover = Net Sales / Average Fixed Assets Accounts Receivables Turnover =Net Credit Sales/ Average Net Accounts Receivables = ----- times

3.

Accounts Receivables Turnover in days (Average Collection Period or Average Age of Receivables) = 365/ Accounts Receivables Turnover = ----- days
4. 5.

Accounts Payable Turnover = COGS / Average Accounts Payable = ----- times

Accounts Payables Turnover in days (Average Age of Payables) = 365/ Accounts Payables Turnover = ----- days
6. 7.

Inventory Turnover = Net Sales or COGS/ Average Inventory = ----- times

Inventory Turnover in days (Average Days Supply in Inventory)

8.

= 365/ Inventory Turnover = ----- days

9.

Quality of Income (Quality of Earning) = Cash Flow from Operating Activities/ Net Income

Market Tests Ratios: 1.Price/Earnings Ratio = Current Market Price Per Share/ Earnings Per Share 2.Dividend Yield Ratio = Dividends Per Share / Market Price Per Share