9/05/2014 Accounting 101

Financial Statement Analysis

Ratio Analysis
Financial statement analysis is undertaken to evaluate a business.
- Is the company profitable and operating efficiently?
- Do the profits represent a good return on investment?
- Is the company financially risky?
The most common technique used to evaluate this is ratios.
- These express relationships between figures shown on the financial statements.
- Allow for comparison of different sized firms.
Ratios only provide meaningful information when they are compared with benchmarks.
Examples of benchmarks:
- Rules of Thumb
- Ratio from an earlier period (trend analysis)
- Ratio from a competitor or industry (cross-section analysis)
Analysts often like to restate the financial statements:
- Common size statements express each financial statement line item in percentage
terms to highlight differences.
- In horizontal analysis each financial statement line item is expressed as a percent of
the base year, this highlights growth, useful for trend analysis.
- Vertical analysis expresses each financial statement line as a percentage of the
largest amount on the statement. I/S (Net Sales) and B/S (Total assets). This helps
distinguish between changes that result from growth and changes that are likely to
have arisen from other causes, this can help forecast future profitability.
Ratio analysis is split into 5 major categories: Profitability, Efficiency, Liquidity, Gearing and
Investment.
Profitability
Profitability ratios measure two aspects of a companys profits:
1. Within the income statement, certain income statement subtotals are shown as
percentages of net sales:
- gross profit percentage
- Profit margin
2. Profitability is related to the assets that helped generate the profit: Return on Assets.


9/05/2014 Accounting 101
Gross profit percentage measures the proportion of each sales dollar (net of returns)
available to pay other expenses and provide profit for owners.
Gross Profit Percentage = Gross Profit / Net Sales
It indicates the effectiveness of marketing, purchasing, pricing and production decisions.
Can be increased by increasing selling price. Or by reducing COGS.
The profit margin percentage measures the proportion of each net sales dollar that is
available to pay interest, taxes, and the owners.
Profit Margin Percentage = EBIT/Net Sales
Different to textbook. EBIT is Earnings before interest and tax.
The return on assets ratio (ROA) measures the profit earned by total assets.
ROA = EBIT / Average Total Assets
ROA = Net Profit After Tax + Tax Expense + Interest Expense / Average Total Assets
Average total assets are used because the profit relates to the entire period.
Gross profit margin less profit margin = operating expenses
Operating Ratios (Asset Efficiency)
Asset efficiency is a measure of how efficiently a company uses its assets. The principal asset
efficiency ratios are measures of turnover, that is, how quickly the business can realize
benefits from certain assets.
- Accounts Receivable turn into Cash (when collected).
- Inventory turns into COGS (when sold).
- Total Assets generate Sales (indirectly).
The faster an asset turns over, the more efficiently it is being used.
Asset turnover ratio: How efficient is the company in generating sales?
Asset Turnover Ratio = Net Sales / Average Total Assets
This combined with profit margin percentage shows that ROA is a mixture of profitability
and efficiency.
ROA can be analysed at 3 levels.
Level 1: ROA = EBIT / Average Assets
Level 2: ROA = Profit Margin x Assets Turnover
Level 3: Profit margin ratios and asset turnover ratios
More asset efficiency ratios:
9/05/2014 Accounting 101
Inventory Turnover Ratio = COGS / Average Inventory
No. of days = 365 days / Inventory Turnover
AR Turnover Ratio = Net Credit Sales / Average Accounts Receivable
No. of days = 365 days / Accounts Receivable Turnover
For external users of the financial statements, net credit sales must be estimated. But many
retailers have insignificant credit sales, e.g., The Warehouse.
Liquidity Risk (Short-term Financial Risk)
This is the risk that a business will not meet its obligations as they become due. Short-term
liquidity ratios are most important to short-term creditors, but all stakeholders have an
interest.
Current Ratio = Current Assets / Current Liabilities
Acid-test Ratio = Current Assets Prepayments Inventory / Current Liabilities
Service companies often see little difference between these 2 methods.
Further liquidity analysis can focus on the Statement of Cash Flows.
Gearing
Financial flexibility is the ability of a business to adapt to change. Gearing is the assessment
of debt levels. This is to assess a businesses long term flexibility. Too much debt reduces
flexibility.
Debt Ratio = Total Debt / Total Assets
Interest Cover Ratio = EBIT / Interest Expense
Investment Ratios
Shareholders have two primary interests:
1. The creation of value
2. The distribution of value
Creation:
EPS = Profit / Weighted Average Common Shares Outstanding
This is the only ratio required to be shown on the face of a financial statement.
P/E Ratio = Market price per share / Earnings per share
This is an indicator of market confidence.
Return on Equity = Profit after Tax / Average Equity
9/05/2014 Accounting 101
ROE is similar to ROA, except that the other stakeholders share of profits (interest and tax
expenses) are removed from the numerator, and claims and assets are removed from the
denominator.
Distribution:
Dividend Yield Ratio = Dividends per Common Share / Closing Market Price per Share for
Year
Usually calculated by an investor who favours dividends over capital gains.
Limitations of Ratio Analysis
1. Effected by quality of financial statements.
2. Restricted view of performance.
3. No 2 businesses are identical.
4. Balance sheet is only a snapshot.