Analysis of Financial Statements

Analysis of Financial Statements

Ms. CameronBAT4MUnit 2

ANALYSIS OF FINANCIAL STATEMENTS

Basis on Which Comparisons can be Made:

  • Intracompany basis: compares a company’s current financials with one or more prior years. Useful for finding financial relationships and significant trends.
  • Intercompany basis: compares item or financial relationship of one company with one or more competing companies. Helps to understand company’s competitive position.
  • Industry Averages: compares an item or financial relationship of a company with industry averages. The averages are determined and published by financial ratings organizations (also Statistics Canada).
  • Comparative financial statements: financial statement amounts for two or more years that are placed side by side in adjacent columns

Tools of Analysis:

Dollar and Percentage Changes:

  • Dollar amount of change from year to year is significant, but expressing the change in percentage terms adds perspective
  • Dollar amount of change:
  • Difference between the amount for comparison year and for the base year
  • Percentage Change:
  • Computed by dividing the amount of change between years by the amount for the base year
  • Computing percentage changes in sales, gross profit, and net income give insight into the company’s growth
  • If a company is experiencing growth, its sales and earnings should increase more than the rate of inflation
  • E.g. company’s sales have increased by 6%, but inflation has increased by 10%. It’s probable that the entire increase in the dollar amount of sales may be explained by inflation rather than an increase in sales volume

Use of Non-Financial Information:

  • Company’s mission, goals, objectives; market position; people; products

RATIO ANALYSIS:

  1. LIQUIDITY RATIOS:
  2. These rations measure the short-term ability of a company to pay its maturing obligations and to meet unexpected needs for cash
  3. Short-term creditors (bankers & suppliers) are particularly interested
  4. some are called short-term solvency ratios

Ratio / Formula / Purpose / Desired outcome
Working Capital / = Current Assets – Current Liabilities / Measures short-term debt paying ability / Nothing specific-difficult to compare $ amount
Current Ratio / = Current Assets / Current Liabilities / Measures short-term debt paying ability / 2:1 is ideal (below or above 3:1 is not good)
Inventory Turnover Rate / = COGS / Average Inventory / Measures liquidity of inventory / Industry average and comparison to previous years
Days to Sell Average Inventory
(Days in Sales Inventory) / = Days in Year / Inventory Turnover / Measures number of days inventory is on hand / Industry average
Accounts Receivables Turnover / = Net Credit Sales / Average Accounts Receivable / Measures liquidity of receivables / The faster the turnover, the more reliable the current ratio is for assessing liquidity
(industry average)
A/R Collection Period / = Days in year / AR Turnover Rate / Measures number of days receivables are outstanding / Industry Average
(also consider credit terms given to customers)
Quick or Acid Test Ratio / = [Cash + AR + Short-term investments] / Current liabilities / Measure short-term debt paying ability without selling inventory / Anything over 1:1

3. PROFITABILITY RATIOS:

  • measure the operating success of the company for a specific period of time
  • a company’s income (or lack thereof) affects its ability to obtain debt and equity financing, its liquidity position and its growth
  • both creditors and investors are interested in evaluating profitability
  • profitability analysis is also used to evaluate management’s operating effectiveness

Ratio / Formula / Purpose / Desired outcome
Earnings Per Share / = NI – pref. dividends / weighted average # of common shares / Measures net income earned on each common share / Only meaningful to compare intracompany—want to increase from previous years
Return on Assets / = operating income / average total assets
(NI / Average total assets—new text) / Measures overall profitability of assets; regardless of how they are financed / Higher is better
Industry average
Return on Common Shareholder’s Equity
(Return on Equity—new text) / = NI – Pref. Dividends / average common shareholder's equity
(= NI / Average shareholder’s Equity) / Rate of return earned upon the common shareholders’ equity / Higher is better
Industry Average
Gross Profit Rate ( Gross Margin Rate) / = Gross Profit / Net Sales / Measures the margin between selling price and COGS; the profitability of the company’s products / Industry Average
(many are 20% +)
Operating Expense Ratio / = Operating Expenses / Net Sales / A measure of management’s ability to control operating expenses / Lower is better
Net Income Rate
(Profit Margin Rate—new text) / = NI / Net Sales / Measure NI generated by each dollar of sales; indicator of management’s ability to control all costs and expenses / Industry average
Higher (say 4%+) is better
Asset Turnover / = Net Sales / Average Total Assets / Measures how efficiently assets are used to generate sales / Higher is better (definitely want higher than 1:1)
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