Week 11 Flashcards
Financial statement analysis requires
Financial information
Standards of comparison (benchmark)
Financial information
Income statement, balance sheet, the statement of cashflow and the statement of changes in equity
Standards of comparison (benchmark)
the prior year(s) of the same company, competitors, industry standards.
Intra-entity basis:
Comparisons within a single entity (detects changes in financial relationships and trends).
Industry averages:
Between entities in same industry (determines position relative to others).
Inter-entity basis:
Between other entities (indicates competitive position).
There are many analysis tools used to conduct a financial analysis. The three most common are:
Horizontal analysis
Vertical analysis
Ratio analysis
Horizontal analysis
Also known as trend analysis. It is a technique that calculates the change in an account balance from one period to the next and expresses that change in both dollar and percentage terms. It is a simple but powerful analysis tool. It reveals significant changes in account balances and therefore identifies items for further investigation.
Horizontal analysis examples
6/10
Vertical analysis
Vertical analysis is a technique that states each account balance on a financial statement as a percentage of a base amount on the statement.
It also allows comparisons of different companies (and the same company over time) by controlling for differences in size.
Vertical analysis examples
6/10
Ratio analysis
Profitability – Measure of success in wealth creation
Liquidity – The ability to meet short-term obligations
Solvency – The ability to satisfy its long term obligations
Profitability analysis
6/10
Return on equity
The return on equity ratio compares profits to the average balance in shareholders’ equity, showing how effectively a company uses the funds provided by shareholders during the year to generate additional equity for its owners.
6/10
Profit margin ratio
The profit margin ratio compares net income to net sales and measures the ability of a company to generate profits from sales. A higher ratio indicates a greater ability to generate profits from sales.
6/10
Return on assets
The return on assets ratio compares income to average total assets
It represents the ability to generate profits from its entire resource base (not just those resources provided by owners).
Measures overall profitability with respect to investment in assets
6/10
Price earnings ratio
The price to earnings ratio compares income to the current market price of the company’s shares, it is an investor’s perception of the company.
A price earnings ratio of 10 means that investors pay ten times current EPS share to buy one share.
A higher price to earnings ratio generally indicates that investors are more optimistic about the future prospects of a company.
Profitability ratios
Measure the profit or operating success of an entity for a given period of time. Profitability is often regarded as the ultimate test of management’s operating effectiveness.
Profitability of an entity affects its:
Ability to obtain debt and equity financing.
Liquidity position.
Ability to grow.
Relationships among profitability measures
6/10 *2
Liquidity analysis
A business’s inability to pay interest and to repay the liabilities is the reason why businesses are placed into administration.
Directors may be personally liable if they allow a company to trade while it is insolvent.
Liquidity analysis (2)
6/10
Current ratio
The current ratio is one of the most frequently used ratios in financial analysis and compares current assets to current liabilities. It compares assets that should be turned into cash within one year to liabilities that should be paid within one year. A higher ratio indicates greater liquidity.
6/10
Quick ratio
The quick ratio (the acid-test ratio) compares a company’s cash and near-cash assets, or quick assets, to its current liabilities.
It also measures the degree to which a company could pay off its current liabilities immediately, a higher quick ratio indicates greater liquidity.
6/10
Receivables turnover
Indicates the effectiveness of credit collection policies.
Measures the number of times trade receivables are converted into cash during the period
The higher the receivable turnover, the shorter the period of time between an entity making credit sales and collecting the cash for the receivable
6/10
Inventory turnover ratio
The inventory turnover ratio measures the number of times on average the inventory sold during the period. Its purpose is to measure the liquidity of the inventory
Inventory turnover is produce specific. A higher ratio is usually desirable.
Reflects the effectiveness of inventory management
6/10
Solvency analysis
Solvency refers to a company’s ability to remain in business over the long term and satisfy its long-term obligations. Solvency is related to liquidity but differs with respect to time frame.
Solvency ratios
Liquidity measures the ability to pay short-term debt, whereas solvency measures a company’s ability to stay financially healthy over the long run.
Solvency focuses on capital structure and assesses the extent of borrowing needed.
Solvency and financial leverage
Financial leverage is the degree to which a company obtains capital through debt rather than equity in an attempt to increase returns to shareholders.
Solvency analysis
It isn’t possible to know if a company will be able to pay future obligations and remain solvent, although some indication of a company’s general solvency include:
debt to assets
debt to equity
times interest earned
debt to assets
debt to equity
times interest earned
These ratios show how a company uses leverage, to create greater returns to shareholders, but also greater solvency risk.
Solvency analysis (2)
6/10
DuPont analysis
A DuPont analysis provides insight into how a company’s return on equity was generated by decomposing the return into three components: operating efficiency, asset effectiveness and capital structure.
3 components of DuPont calculation
- Operating Efficiency
- Effectiveness at using assets
- Business’s capital structure
- Operating Efficiency
calculated as total comprehensive income (net income) divided by sales (the profit margin ratio). This is the ability to turn sales into profits. The higher the ratio, the more efficient a company is in turning sales into profits.
- Effectiveness at using assets
calculated as sales divided by assets (asset turnover ratio). This is the ability to generate sales from assets. The higher the ratio, the more effective a company is in generating sales given its assets.
- Business’s capital structure:
calculated as assets divided by equity. This ratio is similar to the debt to assets and debt to equity ratios in that it measures how a business has financed its assets. The higher the ratio, the more financing with debt rather than equity. A high ratio means more financial leverage, a riskier capital structure. This ratio is sometimes called the leverage multiplier.
DuPont analysis diagram
6/10
Is a company responsible only for its financial performance?
Traditionally it is believed that the sole objective of a company is to maximise shareholder wealth.
However, now it is becoming accepted that companies also have responsibilities to a broader group of stakeholders
Good financial performance is important but not the sole objective.
Companies now being held responsible for their social and environmental as well as their financial performance
Financial accounting measures ignores many of the externalities caused by reporting entities
Focus on the information needs of stakeholders with a financial interest.
Triple-bottom-line reporting
A reposting framework that is more comprehensive than traditional financial performance measure
Integrate financial, environmental and social performance of an entity
Interrelated objectives of triple bottom line reporting
financially secure (e.g. profitability)
minimise or eliminate negative environmental impacts
act in conformity with societal expectations
triple bottom line reporting definition
Sustainable development involves the simultaneous pursuit of economic prosperity, environmental quality and social equity. Companies aiming for sustainability need to perform not against a single financial bottom line, but against the triple bottom line
Growing importance of corporate social and environmental performance
Stakeholder demands information about corporate environmental performance
Global Reporting Initiative- a reporting system that provides performance measures and methods for measuring and reporting sustainability related impact and performance
Integrated Reporting- a broader focus than sustainability reporting; how an organisation creates value over time.
