Transcript Document

CHAPTER 9
Financial statement analysis I
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Contents




The purpose of analysis
Traditional analysis
Tools of analysis
Analysing financial statements
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
The purpose of analysis

Different groups of financial statement
users with different information needs
 Focus
will be on needs of equity investors
and suppliers of credit

Differing levels of technical expertise
 Focus
on tools used by a sophisticated user
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
The purpose of analysis (cont.)

Primary questions relate to company
performance and financial strength, but user
emphasis may differ

Investment analysts are primarily interested in
financial statements as a predictor of future
performance


Lenders will primarily focus on the financial
strength (default risk)
Each question is the sum of different issues
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Traditional analysis

Basis of traditional analysis is relevant

Comparison over time or in space
comparison
 Time
series analysis: comparing company
performance over time
 Cross-sectional
analysis: comparing company
performance with other companies in the
same industry (or industry average)
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Time series analysis



Horizontal analysis
Using a multi-year information base
Trend percentages




Select a base year
Set item amounts of that year = 100%
Corresponding amount of each following year = %
of base mount
Impact of inflation
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Time series analysis- Illustration
Trend percentages of total sales (2000 = 100%)
2005
2004
2003
2002
2001
2000
Sales
(€million)
617
583
492
413
627
445
Sales –
trend %
139%
131%
111%
93%
141%
100%
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Cross-sectional analysis

Comparison with other companies in
the same industry for the same year
 Differences
in company characteristics
should always be accounted for in
interpretation

Comparison with industry averages
 Multi-product
companies
 Definition and size of industry groupings
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Tools of analysis




Common-size financial statements
Use of financial ratios
Management performance ratios
Financial strength ratios
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Common-size financial statements



Standardizing financial statements by
introducing a common denominator
In a common-size balance sheet each
component of the balance sheet is expressed
as a percentage of total assets
In a common-size income statement each
item is expressed as a percentage of sales
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Common-size financial statements
(cont.)


Allow comparison of companies of different
size (in terms of total assets and sales)
Allow (internal) structural analysis of the
financial statements of a company


Relative magnitude of asset, liability, equity and
income statement components
Combination of horizontal and vertical
analysis
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Common-size balance sheet - Illustration
Published
€m
Common size
%
Assets
Fixed assets
Tangible assets
Investments
113.9
8.6
22.4
1.7
53.2
218.6
114.3
10.5
43
22.4
508.6
100
111.6
201.3
3.1
24.1
168.5
22
39.6
0.6
4.7
33.1
Current assets
Inventories
Receivables
Bank
Totals
Liabilities and equity
Trade and related liabilities
Short-term borrowing
Long-term borrowing
Provisions
Equity
Totals
508.6
100
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Common-size income statement - Illustration
Published
€m
Common size
%
5,356
(2,601)
100
(48.6)
2,755
51.4
Distribution costs
Administrative expenses
(382)
(874)
(7.1)
(16.3)
Profit before interest and tax
1,499
28.0
Interest
(362)
(6.8)
Profit before taxation
1,137
21.2
Taxation
(384)
(7.1)
Net profit for the period
753
14.1
Sales
Cost of sales
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Use of financial ratios


A financial ratio expresses the mathematical
relationship between two or more financial
statement items that are logically linked
Comparison over time and in space



Like must always be compared with like
Combined use of financial ratios is more
informative
Financial ratios as indicators of management
performance and financial strength
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Management performance ratios




Profitability and asset utilization ratios
Margin ratios (return on sales) show how
successful management is in creating profit
from a given quantity of sales
Return on investment ratios take into account
the investment needed to generate the profit
Asset utilization ratios measure how efficient
management uses the company’s assets
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Table 9.1 Profitability ratios
Net profit margin
=
Net profit after tax
Sales
Gross operating margin
=
Sales less Cost of sales
Sales
Net operating margin
=
Net profit before interest and tax
Sales
Return on equity (ROE)
=
Return on assets (ROA)
=
=
Net profit after tax
Equity
Net profit before interest
Total assets
Net profit after tax + (interest * (1-tax rate))
Total assets
Return on capital employed (ROCE)
Earnings per share (EPS)
=
=
Net profit before interest on LT-debt
Equity + LT-debt
Net profit after tax
Number of shares outstanding
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Margin ratios

Main ratios:
 Gross
operating margin
 Net operating margin
 Net profit margin


Measure operating efficiency
Tend to be highly industry-specific
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Return on investment ratios

Main ratios:





Return on equity (ROE)
Return on assets (ROA)
Return on capital employed (ROCE)
Each reflects the profit generated by a
specific pool of funds, excluding the costs of
the specific funds considered
Different denominators (investment base)
and numerators (profit figure retained)
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
ROI - perspectives



ROE measures how much a company has
earned on the funds invested by its
shareholders (shareholder perspective)
ROA shows how well a company’s funds were
used, irrespective of the relative magnitudes
of the sources of these funds (current
liabilities, debt and equity)
ROCE shows how much a company has
earned on invested long-term funds
(permanently employed capital = equity + LT
debt)
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Figure 9.1 Capital employed
Fixed assets
Net working capital
Current assets
Financing
Equity
LT Debt
Current liabilities
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Capital employed
Capital employed
Assets
Earnings per share (EPS)



Shows how much of a period’s net profit has
been earned by each ordinary share outstanding
(basic EPS) or by shares outstanding plus all
potential shares (diluted EPS)
Potential shares are equity instruments issued
that can be converted into ordinary shares at
the option of the holder of the instrument
IAS 33 Earnings per Share requires that listed
companies disclose both basic and diluted EPS
on the face of the income statement
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Price/earnings ratio
EPS is used as input to a market ratio, the price/earnings or
P/E ratio:
Market price per share
Price/Earnings =
EPS
•Reflects how the market (market price) judges the company’s
performance (growth expectations)
•It is an inverted rate of return ratio
•Also called the Earnings Multiple
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Dividend yield ratio
The dividend yield ratio reflects the relationship between the
dividends per share paid to shareholders and the current market
price of a share:
Dividend Yield =
Dividend per share
Market price per share
Both P/E and dividend yield ratios of listed companies are
published daily by major financial newspapers
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Asset utilization ratios

Main ratios:






Total asset turnover
Fixed asset turnover
Inventory turnover
Receivable turnover
Turnover ratios measure efficiency of use of
(categories of) assets
Tend to be industry-specific
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Table 9.1 Asset utilization ratios
Total asset turnover
=
Sales
Total assets
Fixed asset turnover
=
Sales
Fixed assets
Inventory turnover
=
Cost of sales
Inventories
Receivables turnover
=
(Net credit) Sales
Receivables
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Financial strength ratios



Indicate the strength of a company’s financial
position from the point of view of long-term
solvency risk and short-term liquidity risk
Solvency refers to the long-term ability to
generate cash internally or from external
sources in order to meet long-term financial
obligations
Liquidity refers to the ability to generate cash
to meet short-term obligations
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Long-term solvency risk ratios

Main ratios:





Debt/equity ratio
Gearing ratio
Interest and dividend cover
Gearing as indicator of default risk
Debt financing introduces financial risk
because it implies fixed commitments in the
form of interest payments and principal
repayment and exposure to interest rate
movements
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Table 9.2 Long-term solvency risk ratios
Gearing (Debt/equity ratio)
=
Debt
Equity
This ratio is also frequently computed on the basis of debt to total finance:
Gearing (Total finance)
=
Debt
Debt + Equity
Interest cover
=
Profit before interest and tax
Net interest charges
Dividend cover
=
Earnings per share
Dividend per share
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Short-term liquidity risk ratios

Main ratios:





Current ratio and acid-test ratio
Credit given and credit obtained
Days inventory outstanding
Liquidity tests focus on the make-up of
working capital and the activity level of its
components
Low liquidity implies financial risk as inability
to service short-term debt payments may
lead to higher interest expense and,
eventually, bankruptcy
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Table 9.2 Short-term liquidity risk ratios
Current assets
Current liabilities
Current ratio
=
Acid test (or quick ratio)
=
Days inventory
outstanding
=
Inventories
Cost of sales
* 365 days
Credit given
=
Receivables
(Credit) Sales
* 365 days
Credit obtained
=
Current assets – Inventories
Current liabilities
Similarly:
Trade payables
redit obtained* 365 days
Cost of sales
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Analysing financial statements





Decode messages built into financial
statements and use them to ‘tell the story’
Time series analysis of ratios
Combine patterns of financial ratios
Compare cross-sectionally
Ratio analysis is only part of an investment
appraisal process - also consider:



Non-financial performance indicators
Broader economic variables
Information about future business plans, etc.
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Worked example (1)
20X7
€’000
20X8
€’000
20X9
€’000
620.0
-217.0
403.0
-204.6
-95.1
103.3
-10.0
93.3
-32.7
60.6
745.0
-245.8
499.2
-260.7
-97.2
141.3
-30.9
111.3
38.9
72.4
762.0
-266.7
495.3
-266.7
-101.4
127.2
-37.5
98.7
-31.4
67.3
Income statements:
Sales
Cost of sales
Gross Margin
Distribution costs
Administrative expenses
Interest
Taxation
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Worked example (2)
Balance sheets:
Net fixed assets
Inventories
Receivables
Cash
Ordinary shares (€1)
Reserves
Debt
Trade payables
Taxes payable
20X7
€’000
20X8
€’000
20X9
€’000
312.0
43.4
62.0
67.0
484.4
120.0
195.5
315.5
100.0
36.2
32.7
484.4
532.0
49.2
74.5
70.3
726.0
120.0
267.9
387.9
250.0
49.2
38.9
726.0
495.0
66.7
91.4
58.0
711.1
120.0
315.2
435.2
200.0
44.5
31.4
711.1
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Worked example (3)
20X7
20X8
60.6 / 315.5
=19.21%
72.4 / 387.9
=18.66%
67,3 / 435.2
=15.46%
ROA
(60.6+(10*(1-0.3)))/
484.4
=13.96%
(72.4+(30.9*(1-0.3)))
/726
=12.95%
(67.3+(37.5*(1-0.3)))
/711.1
=13.16%
ROCE
(60.6+(10*(1-0.3)))/
(315.5+100)
=16.27%
(72.4+(30.9*(1-0.3)))/
(387.9+250)
=14.74%
(67.3+(37.5*(1-0.3)))/
(435.2+200)
=14.73%
60.6/120
=50.50
72.4/120
=60.33
67.3/120
=56.08
(620-217)/620
=65.00%
(745-245.8)/745
=67.01%
(762-266.7)/762
=65.00%
103.3/620
=16.66%
141.3/745
=18.97%%
127.2/762
=16.69%
60.6/620
=9.77%
72.4/745
=9.72%
67.3/762
=8.83%
20X9
Management Performance ratios
A. Profitability ratios
ROE
EPS
Gross operating margin
Net operating margin
Net profit margin
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Worked example (4)
20X7
20X8
20X9
Total asset turnover
620/484.4
=1.28
745/726
=1.03
762/711.1
=1.07
Fixed asset turnover
620/312
=1.99
745/532
=1.40
762/495
=1.54
Inventory turnover
217/43.4
=5.00
245.8/49.2
=5.00
266.7/66.7
=4.00
620/62
=10.00
745/74.5
=10.00
762/91.4
=8.34
B. Asset utilization ratios
Receivables turnover
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Worked example (5)
20X7
20X8
20X9
100/315.5
=31.70%
250/387.9
=64.45%
200/435.2
=45.96%
100/(100+315.5)
=24.07%
250/(250+387.9)
=39.22%
200/(200+435.2)
=31.49%
Interest cover
103.3/10
=10.33
141.3/30.9
=4.57
127.2/37.5
=3.39
Dividend cover
60.6/20.0
=3.03
72.4/20.0
=3.62
67.3/20
=3.37
Financial strength ratios
A. Long-term solvency risk ratios
Gearing
Gearing (Total finance)
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Worked example (6)
20X7
20X8
20X9
(43.4+62+67)/
(36.2+32.7)
=2.50
(49.2+74.5+70.3)
/(49.2+38.9)
=2.20
(66.7+91.4+58.0)
/(44.5+31.4)
=2.85
(62+67)/
(36.2+ 32.7)
=1.87
(74.5+70.3)/
(49.2+38.9)
=1.64
(58.0+91.4)/
(31.4+44.5)
=1.97
(43.4/217)*365
=73.00
(49.2/245.8)*365
=73.06
(66.7/266.7)*365
=91.28
(62/620.0)*365
=36.50
(74.5/745)*365
=36.50
(91.4/762)*365
=43.78
(36.2/217.0)*365
=60.89
(49.2/245.8)*365
=73.06
(44.5/266.7)*365
=60.90
B. Short-term liquidity ratios
Current ratio
Acid test
Days inventory
outstanding
Credit given
Credit obtained
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Worked example (7)
Growth:
20x7/x8
20x8/x9
Sales
20.16%
2.28%
Profit
19.47%
-7.04%
Capital employed
53.53%
-0.42%
Net fixed assets
70.51%
-6.95%
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts