Introduction to financial statements analysis



Introduction to financial statements analysis THE PURPOSE OF ANALYSIS Different groups of financial statement users with different information needsFocus will be on needs of equity investors and suppliers of credit Different levels of technical expertiseFocus on tools used by a sophisticated user Primary questions relate to company performance and financial strength, but user emphasis may differ Investment analysts are primarily interested in financial statements as a predictor of future performance Lenders will primarily focus on the financial strength (Default risk) Each question is the sum of different issuesTRADITIONAL ANALYSIS Basis of traditional analysis is relevant comparisonComparison over time or in space Time series analysis: comparing company performance over timeCross-sectional analysis – comparing company performance with other companies in the same industry (or industry average)Time series analysis Horizontal analysis Using a multi-year information baseTrend percentages Select a base year Set item amounts of that year = 100% Corresponding amount of each following year = % of base mount Impact of inflation Cross-sectional analysisComparison with other companies in the same industry for the same year Differences in company characteristics should always be accounted for in interpretation Comparison with industry averages Multi-product companiesDefinition and size of industry groupings TOOLS OF ANALYSIS Common size financial statements Standardizing financial statements by introducing a common denominator In a common-size balance sheet, each component of the statement of financial position is expressed as a percentage of total assets In a common size statement of profit or loss, each item is expressed as a percentage of sales Allow comparison of companies of different size (in terms of total assets and sales) Allows internal structural analysis of the financial statements of a company Relative magnitude of asset, liability equity and P/L statement components Combination of horizontal and vertical analysis Use of financial ratios A financial ratio expresses the mathematical relationship between two or more financial statement items that are logically linked Comparison over time and in spaceLike must always be compared with like Combined use of financial ratios is more informative Financial ratios as indicators of management performance and financial strength MANAGEMENT PERFORMANCE RATIOS Profitability and asset utilization ratios Margin ratios (returns on sales) show how successful management is in creating profit from a given quantity of sales Return on investment ratios take into account the investment needed to generate the profit Asset utilization ratios measure how efficient management uses the company’s assets Profitability ratiosMargin ratios Main ratios Gross operating marginNet operating margin Net profit margin Measures operating efficiency tend to be highly industry specific Return on investment ratios Main ratio Return on equity (ROE) Return on assets (ROA)Return on capital employed (ROCE) Each reflects the profit generated by a specific pool of funds, excluding the costs of the specific funds considered Different denominators (investment base) and numerators (profit figure retained) ROI – Perspectives ROE measures how much a company has earned on the funds invested by its shareholders ROA shows how well a company’s funds were used, irrespective of the relative magnitudes of the sources of these funds (current liabilities, debt and equity)ROCE shows how much a company has earned on invested long-term funds (permanently employed capital = equity + LT debt) Earnings per share (EPS) Shows much of a period’s net profit has been earned by each ordinary share outstanding (Basic EPS) or by shares outstanding plus all potential shares (diluted EPS) Potential shares are equity instruments issued that can be converted into ordinary shares at the option of the holder of the instrument IAS 33 Earnings per share requires that listed companies disclose both basic and diluted EPS on the face of the statement of profit or loss Price / earnings ratioEPS is used as input to a market the price/earnings or P/E Reflects how the market (market price) judges the company’s performance (growth expectations) It is an inverted rate of return ratioAlso called the Earnings Multiple Dividend yield ratioReflects the relationship between the dividends per share paid to shareholders and the current market price of a share: Both P/E and dividend yield ratios of listed companies are published daily by major financial newspapers Asset utilization ratios Main ratiosTotal asset turnoverLong-term asset turnoverInventory turnoverReceivable turnover Turnover ratios measure efficiency of use of (categories of) assets Tend to be industry specific FINANCIAL STRENGTH RATIOS Indicates the strength of a company’s financial position from the point of view of long term solvency risk and short term liquidity risk Solvency refers to the long-term ability to generate cash internally or from external sources in order to meet LT financial obligations Liquidity refers to the ability to generate cash to meet ST obligations Long term solvency risk ratios Main ratios Debt/ equity ratio Gearing ratioInterest and dividend coverGearing as indicator of default-risk Debt financing introduces financial risk because it implies fixed commitments in the form of interest payments and principal repayment and exposure to interest rate movements Short-term liquidity risk ratios Main ratios Current ratio and acid-test ratioCredit given and credit obtained Days inventory outstanding Liquidity tests focus on the make-up of working capital and the activity level of its components Low liquidity implies financial risk as inability to service short-term debt payments may lead to higher interest expense and, eventually bankruptcy ANALYSIS FINANCIAL STATEMENTS Decode messages built into financial statements and use them to tell the story Time series analysis of ratios Combine patterns of financial ratios Compare cross-sectionally Ratio analysis is only part of an investment appraisal process – also consider:Non-financial performance indicatorsBroader economic variables Information about future business plans ................
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