Financial Statement Analysis by JeanLuc Pagnon

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Financial Statement Analysis(by Jean-Luc Pagnon)

• Introduction

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Jean-Luc Pagnon? Who is He?

• Full time Professor and Finance area coordinator
  at the Groupe Sup de Co Amiens Picardie (ISAM
  ESC),
• Associated Professor at the ESIEE Amiens
  ( Masters in International Business
  Management  ) ,
• Casual Professor at the Université Pierre et
  Marie Curie (Paris VI) (Master  Science et
  Management ), and at the ESC Rouen,
• Former visiting Professor at Aston Business
  School (England) and at the West-Bohemia
  University (Czech Republic).
• Former Controller (Chief Financial Officer) of
  medium sized subsidiaries of multinatrional
  groups Vivendi (Utilities), Total (Oil
  industry), Fortschritt AHB (Farm machinery).

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Module Objective

• This course will not make you a financial
  expert.
• However, it will help you be able to evaluate a
  business entitys financial statements and
  provide analysis of performance.

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Contents

• What is Financial Statement Analysis?
• Financial statements
• Methods of Financial Statement Analysis
• Key Questions
• Ratio Analysis
• Financial and Nonfinancial Measures of Success

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Teaching Methods

• Lectures
• Exercises and Case studies
• Working language English

6
Method of Assessment

• Multiple Choice Quiz (50),
• Final Exam (50).

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Advisable Reading

• Accounting An Introduction by Eddie McLaney
  and Peter Atrill, FT Prentice Hall,
• Accounting for Non-Accounting Students
• by John R. Dyson, FT Prentice Hall
• Financial Ratio Analysis by Dr. P. Peterson,
• Lecture notes

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Financial Statement Analysis
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What is Financial Statement Analysis?

• A technique whereby users analyse past financial
  data to determine an entitys present financial
  position and predict future performance.
• Information from the financial statements is
  used to highlight trends and identify an entitys
  strengths and weaknesses.

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Users of financial information

• Present and potential investors
• Individuals,
• Institutionals
• Pension funds,
• Insurance companies,
• Investment companies,etc.
• Creditors
• Employees and unions
• Business contacts
• Financial analysts and personal financial
  advisors

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The Financial Statements

• Balance Sheet (or Statement of Financial
  Position)
• Income Statement (or Profit and Loss Account)
• Statement of Changes in Equity
• Statement of Cash Flows

2-11
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Balance Sheet (Statement of Financial Position)
Assets
Liabilities and Equity
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Balance Sheet Components

• Assets
• An asset is anything that the business owns.
• Liabilities
• Liabilities are debts or obligations of the
  business that result from past transactions and
  will be paid with assets or services in the
  future.
• Stockholders Equity (Owners Equity)
• Equity is the amount of financing provided by
  owners of the business (Paid-in Capital) and
  operations (Retained Earnings).

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Basic Balance Sheet Equation (Basic Accounting
Equation)
Assets Liabilities Equity
Economic resources Sources of financing . .
. Liabilities from creditors Equity
from stockholders.
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Income Statement (Profit and Loss Account, PL)
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Income Statement ComponentsBasic Income
Statement Equation

• Revenues The value of goods or services sold.
• Expenses The value resources used to earn
  revenues.
• Revenues Expenses Net Income (Loss)

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Financial Statements Exercise

• Interest expense 9,000 Land 32,000
• Paid in capital 20,000 Retained
  earnings 141,000
• Notes payable 70,000 Cash 36,000
• Rent expense 18,000 Cost of goods sold 440,000
• Merch. Inventory 210,000 Equipment 18,000
• Accounts receivable 48,000 Income tax expense
  60,000
• Depreciation expense 3,000 Accounts payable
  23,000
• Sales revenue 620,000
• Prepare a balance sheet and a PL for the company!

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Dividends / Retained Earnings
Net Income
Dividends paid to
Stockholders
Retained Earnings
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Owners Equity Components
Assets Liabilities Owners Equity
Paid in capital (Stock)
Retained Earnings
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Owners Equity Components

• Paid in Capital (Contributed Capital, Stock)
• The amount invested in the entity by the owners.
• Retained Earnings
• Cumulative net income that has not been
  distributed to the owners of a corporation as
  dividends.

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Retained Earnings Equation

• Beginning RE Balance
• Plus Net Income
• Less Dividends
• Ending RE Balance

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Exercise

• Calculate the missing amounts for each firm
• Firm A Firm B
• Total assets ? 435,000
• Liabilities 80,000 ?
• Paid in capital 55,000 59,000
• Retained earnings (end.) ? 186,000
• Net income for year 68,000 110,000
• Dividends for year 12,000 ?
• Retained earnings (begin.) 50,000 124,000

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Components of the Statement of Cash Flows

• Cash Flows From Operating Activities
• Cash flows directly related to earning income
• (i.e.., related to the operating activities of
  the business)
• Cash Flows From Investing Activities
• Cash flows related to the acquisition or sale of
  productive assets (e.g.. property, plant and
  equipment) used in the business.
• Cash Flows From Financing Activities
• Cash flows directly related to the financing of
  the business (i.e.., debt and equity)

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Financial Statement Analysis

• Key Questions

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3 Key Questions

• Is the business growing?
• Is the business profitable?
• (Does it generate adequate returns to its
  resources?)
• Is the business solvent?
• (Can it pay its debts as they become due?)

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Analyzing the Profit and Loss StatementIs the
business growing?

• Quality Indicator of sales growth/decline
• Are sales increasing at a growth greater than the
  inflation rate?
• NB  Trend Analysis  consists in comparing key
  figures over a series of successive periods.

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Analyzing the Profit and Loss StatementIs the
business profitable?

• Quality indicators
• Earnings Before Taxes)/Sales
• Operating Profit/Sales
• Is the of OP/Sales and EBT/Sales increasing
  with growth?

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Analyzing the Profit and Loss StatementIs the
business profitable?

• Does the business control its Direct Cost?
• Quality Indicator COGS/Sales
• Does the Business Control Overhead Cost?
• Quality Indicator Operating and Administrative
  Expenses/Sales

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Analyzing the Balance SheetIs the business
solvent?

• Quality Indicator Net Cash Position
• NCP Liquid assets ( cash, marketable securities
  and short term investments) - Short term
  borrowings (short term bank loans)

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Important! A company must finance not only its
fixed assets but also its day to day operations

• The operating cycle is the time period from
  inventory purchase until the receipt of cash.
• The cash cycle is the time period from when cash
  is paid out to when cash is received.

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Working Capital (WC), Working Capital
Requirement (WCR), and Net Cash Position (NCP)

• The funds available after a company has financed
  its long term assets are called Working
  Capital.
• WC Permanent Capital (LT debts Equity) - Net
  Fixed Assets
• The funds necessary to finance its day to day
  operations are called Working Capital
  Requirement or Net Working Capital .
• WCR ( Net WC) Current assets associated with
  the operating cycle () - Current liabilities
  associated with the operating cycle ().
• () Of which inventory and accounts receivable.
  () Of which accounts payable
• WC says how much the company brings to the
  operating cycle.
• WCR says how much the company needs for the
  operating cycle.
• The difference between WC and WCR is the Net
  Cash Position.

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Fundamental equation NCP WC - WCR

• If WC gt WCR The company has a positive net
  cash position.
• If WC lt WCR The company has a negative net
  cash position (need for short term borrowings).
• What is important is not the level of WC as such
  but its relation with the WCR. (A company with a
  high WC might be in financial difficulties if its
  WCR is higher)

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Variation NCP Variation WC - Variation WCR

• Liquidity is a direct consequence
• of decisions affecting the WC (strategic
  decisions)
• investment or divestment,
• stock issue or share repurchases,
• long term debt issue or retirement,
• dividend decisions which have an impact on the
  retained earnings level.
• and decisions affecting the WCR operating
  decisions changing
• the level of inventories,
• accounts receivable,
• accounts payable.

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Important!

• A firm in a period of growth should expect an
  increase of its WCR.
• (WCR increases with the firm's sales even if
• same inventory turnover,
• same collection period,
• same suppliers' credit terms.)
• Operating managers (in the production field, or
  in the commercial activities, or in purchasing
  functions) influence the liquidity of the firm
  every day.
• The WCR may change with the seasonal activity of
  the business.

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Analyzing the Balance SheetIs the business
solvent?

• Does the Business Collect its Bills?
• Quality indicator Account Receivables/Sales365
  days
• Measures the average number of days it takes to
  collect bills
• Does the business control its inventory?
• Quality Indicator Inventory/COGS365 days
• Measures the average number of days worth of
  inventory on hand
• Does the Business Pay its Bills?
• Quality indicator Accounts Payables/COGS365
  days
• Measures the average number of days its takes to
  pay suppliers

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Analyzing the Balance SheetIs the business
solvent?

• Have the owners invested in the business?
• Reinvested profits, investment in common stock,
  deferred officers salary?
• Has the business produced a positive net worth?
• Positive retained earnings indicate that the
  company has been profitable and has reinvested
  profits into operations
• Negative retained earnings indicates the company
  has experienced losses
• Does the business match its sources and uses of
  funds?
• Is there adequate short-term debt financing for
  short-term or seasonal working capital needs?
• Are fixed assets financed by long- term debts?
• Short term and Long term debt/Net worth measures
  the percent of the company financed by lenders
  relative to owner (Fact Most private sector
  lender wont finance companies with more than 21
  ratio. Public lenders may go up to 51).

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Financial Statement Analysis

• Ratio Analysis

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Ratio Analysis - Limitations

• Ratios mean nothing on their own.
• To be useful a ratio must be compared with
• Ratios from a previous period
• The same ratio from a different firm (within the
  same industry)
• An industry average or benchmark.
• Ratios indicate that a problem exists but do not
  identify the problem itself.

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Ratio Analysis - Limitations

• Ratios are based on information which is
  out-of-date.
• Changes in accounting policy may effect the
  analysis.

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Ratio Analysis - Usefulness

• Quick to calculate and simple to interpret.
• Brings figures down to a common scale (i.e. ).
• Shows the relationship between two variables
  (e.g. Net Profit as a percentage of Sales).

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Types Of Ratios

• Liquidity
• Enables the analyst to evaluate the ability of
  an entity to repay its short term liabilities as
  they fall due.
• Profitability
• Designed to help an analyst evaluate a firms
  ability to control expenses and earn an adequate
  return.

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Types Of Ratios

• Efficiency
• Provide an insight into how well a firm is
  controlling and managing its available resources.
• Leverage
• Measures the extent to which an entity relies
  upon debt financing.
• Market-based
• Show the yield of an entitys shares (based on
  current share price), and how attractive shares
  are to investors.

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Liquidity Ratios

• Current Ratio Current Assets
• Current Liabilities
• If lt 1 Entity cant meet obligations to
  creditors.
• If too far gt 1 Inefficient use of resources.

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Liquidity Ratios

• Quick Ratio Current Assets - Stock -
  Prepayments
• Current Liabilities - ST bank loans
• The quick ratio provides a more realistic
  indication of liquidity by removing less liquid
  items. It measures the ability of an entity to
  repay creditors without doing anything drastic.

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Profitability Ratios

• Gross Profit Ratio Gross Profit
• Sales
• This ratio shows the amount of gross profit that
  is earned for every 1 of sales.

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Profitability Ratios

• Net Profit Ratio Net Profit
• Sales
• Shows the amount of net profit earned for every
  1 of sales.

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Profitability Ratios

• Return on Assets Net Profit
• (R.O.A.) Total Assets
• Shows the earning power of total assets.

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Profitability Ratios

• Return on Equity Net Profit
• (R.O.E.) Equity
• Shows the profit generated per dollar of
  shareholders investment.

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Efficiency Ratios

• Debtors Turnover Average Debtors
• Credit Sales/365
• If the debtors turnover ratio is increasing,
  collection policy is deteriorating
• Higher risk of bad debts,
• Opportunity cost of lost income.
• Corrective Action
• Reduce credit facilities,
• Improve collection procedure.

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Efficiency Ratios

• Inventory Turnover Ratio Average Inventory
• COGS / 365
• Shows the appropriateness of a firms
  inventory level.
• If the level of inventory is excessive it
  will lead to increased carrying costs
• Opportunity cost (ie too much money tied up in
  inventory),
• Increased storage costs,
• May lead to subsequent losses,
• Increased insurance premiums.

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Leverage Ratios

• Interest Coverage Ratio Net Profit Tax
  Interest
• Interest
• EBIT/interest expense
• Measures the number of times interest expense is
  covered by net profit.
• This ratio is favored by long term creditors.
  Before investing in long term securities they
  want to be assured that the entity is in a
  position to pay the relevant interest for the
  duration of the security.

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Leverage Ratios

• Debt to Equity Ratio Total Liabilities
• Equity
• Shows the financial structure of the firm.
• If the Debt to Equity ratio is increasing, more
  of the firms operations are financed by debt
  leading to
• Increased interest payments,
• Increased risk of failure.

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Leverage Ratios

• Debt to Total Assets Ratio Total Liabilities
• Total Assets
• Shows the proportion of total assets financed by
  debt.

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Market-based ratios

• Price/Earnings ratio (P/E ratio)
• Share price, compared to profit-per-share
• (a P/E of 7 means that investors are willing to
  pay 7 times more for a share, than current
  earnings-per-share).
• A high P/E means the sharemarket is confident in
  the company.
• Dividend Yield dividend-per-share/ current
  share price (equivalent to interest rate earned
  on a bank deposit)

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Financial Statement Analysis

• Financial and Nonfinancial Measures of Success

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Financial Measures of Success

• Sales growth
• Earnings growth
• Dividend growth
• Bond and credit ratings
• Cash flow
• Increase in stock price

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Nonfinancial Measures of SuccessCustomer
Measures

• Market share, and growth in market share
• Customer service
• On-time delivery
• Customer satisfaction
• Brand recognition
• Positions in favorable markets

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Nonfinancial Measures of SuccessInternal
Business Processes

• High product quality
• Manufacturing innovation
• High manufacturing productivity
• Cycle time
• Yield, reduction in waste

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Nonfinancial Measures of SuccessLearning and
Innovation

• Competence and integrity of managers
• Morale and firm-wide culture
• Education and training
• Innovation

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Financial Statement Analysis

• END of Chapter