Lecture 4 Financial Statement Analysis Flashcards
Why we need financial statement analysis?
provide useful information for:
- investors to buy, sell or hold securities
- lenders to make lending decisions
- managers to identify areas to be improved
4 different aspects of financial analysis
- profitability
- liquidity
- solvency
- efficiency
involves comparisons between:
past values
competitors’ values
industry norms
what to be consider when making financial analysis
- ratios are standardised data
- beware of different ratio definition
- difference in accounting standards
- observe trends
- requires understanding of company, industry, economy context
Common size analysis
each item in:
- income statement - % of net sales revenue
- balance sheet - % of total assets`
Horizontal analysis
annual percentage change of each item in income statement and balance sheet
ROE = (1-tax rate)[ROA + (ROA-interest rate)(Debt/Equity)]
what happens when ROA>/< interest rate?
when ROA>interest rate:
- borrowed money creates more than interest payment and provides surplus earnings for equity holders
- ROE increased above (1-tax rate)ROA
- higher leverage ratio leads to higher ROE
when ROA
what are the two business strategies?
Product differentiation: offer products with unique benefits (high quality/ unique style or features) to charge higher prices
Cost differentiation: operate more efficiently than competitors to offer lower prices to attract customers
Downside of accounting ratios
- debt, equity and assets are book value, can be quite different from market values
- assets are affected by depreciation methods and can be manipulated
- intangible assets developed through firm’s R&D, marketing are not recognised
- > asset might be understated
- > performance is overstated
what is the use of liquidity ratios?
- help lenders determine id they should make short term loan to the firm
- measures the firm’s ability to meet short term obligations when due
why does firms need short term borrowing?
to cover short falls between cash receipts from customers and cash payments to suppliers
is liquidity ratios reliable?
yes, book values and market values of liquid assets do not differ much
- but they get outdated quickly as short term assets and liabilities change quickly
- high liquidity ratios reduce insolvency risk, but is costly (they need to hold more current asset such as inventories, which involves inventory cost and management cost)
what is solvency?
the company’s ability to meet long term obligations
default risk is a function of:
- firm’s capacity to generate cash from operation
- financial obligations
when is the probability of bankruptcy is higher?
- low and declining profitability
- high debt ratios
- low interest coverage
- decreasing cash reserves and working capital
