Lecture 11 - Financial Statement Analysis

Question 1

Describe the Horizontal Analysis and its 2 steps

Answer 1

= The study of percentage change from year to year eg. sales revenue and operating profit

1) Compute the amount of change from 1 period (base period) to the next

2) Divide the amount of change by the base period amount

Question 2

Describe Vertical Analysis and its 2 steps

Answer 2

-Shows the relationship of financial statement items relative to a total which is the 100% figure
-A way to compare companies more easily

1) Select base whose amounts are set equal to 100%

2) All items on a particular financial statement are stated as a percentage of the base amount.

Example from Income Statement:
Net sales 100%
COGS 40%
Gross profit 60%
Operating expense 27%
Income tax expense 10%
Net income = 23%

Question 3

Mention 4 commonly used Financial Ratios that financial analysists rely on and combine

Answer 3

1) Efficiency Ratios
2) Financial Strengths Ratios
3) Profitability Ratios
4) Investment Ratios

Question 4

What are Efficiency Ratios?

Mention 3, explain them and the formula

Hint: Number of times per year

Answer 4

-Measures an entity’s ability to collect cash
-Especially crucial for companies that buy or make goods for sale as it shows how well they can sell inventory, collect receivables and manage their payables.

1) Inventory Turnover
-Measures the number of times the company sells its average level of inventory during a year- the higher the better

= COGS/Average inventory@
@Average inventory = (Beginning + ending balance)*2

2) Accounts receivable turnover
-Measures ability to collect cash from costumers
-Tells how many times a year the average receivables are turned into cash
-The higher the better

=Net credit sales/average net accounts receivables

3) Accounts payable turnover
-Measures number of times per year a company pays off its accounts payable
-Generally a lower payable turnover is the best as the company is making full use of the credit terms

Question 5

What are Financial Strength Ratios?

Mention 3, describe them and the formula

Answer 5

-Measures an entity’s ability to meet its financial obligations either in the short-term or long-term

1) Current ratio
-Measures ability to pay current liabilities with current assets
-A higher ratio indicates a stronger financial position - ideally higher than 1

= Current assets/current liabilities

2) Debt ratio
-Expresses relationship between liability and assets - how many assets that comes from liabilities
-Ratio of 1 indicate that debt financed all assets
-The lower the ratio the lower the risk

= Total liabilities/ total assets

3) Times-interest-earned ratio /interest-coverage ratio
-Measures the number of times operating income can cover interest expense
-High ratio indicates ease in paying interest

Question 6

What are Profitability Ratios?

Mention 3 and explain them

Answer 6

-Measures profitability

1) Gross proft/net profit margin percentage
-Shows the percentage of each sales dollar earned as gross and net profit

Gross profit margin = gross profit/ sales
Net profit margin = Net profit / sales

2) Return on total assets ROA
-Measures the succes of using assets to earn profit

ROA = net income/average total assets

3) Return on Equity ROE
-Usually the most important for investors
-Shows relationship between net income and ordinary shareholders’ equity investment in an entity –> How much income that is earned per dollar invested
ROE = (Net income - preference shares)/average ordinary shareholders’ equity

Question 7

What are Investment Ratios?
Mention 3 and explain them and their formulas

Answer 7

-Measures how much each share they own is generating profit, cash and dividends

1) Earnings Per Share EPS
-Key measure of a business succes
-The amount of net income earned for each outstanding ordinary share

EPS = (net income-preference shares) / weighted-average number of ordinary shares outstanding

2) Price/Earnings P/E Ratio
- Shows how much an investor is willing to pay each unit of earning

P/E = market price per ordinary share/earnings per share

3) Dividend Yield
-Shows the percentage of a share’s market value returned as dividends to shareholders each period

=Dividend per ordinary (or preference) share/ market price per ordinary (or preference) share

Question 8

What should financial ratios be compared to? (3)

Answer 8

1) Prior year ratios
2) Competitor’s ratios
3) Industry average