Why do we need financial statement analysis

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Why do we need financial statement analysis?

• To understand the economics of a firm and
• To help forecast its future profitability and
  risk
• Profitability is an increase in wealth
• Risk is the probability that a specific level of
  profitability will be achieved.

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How do we assess performance?

• Purpose to increase shareholders wealth
• Measure past performance in terms of operations,
  investing and financing
• Create positive cash flows from all of the areas
  in order to create cash that exceeds companys
  cost of capital
• Various techniques available, trend analysis,
  ratio analysis

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Trend Analysis

• Analytical Analysis
• Vertical Analysis
• Express the items in the financial statements as
  a percentage of total assets or sales
• Horizontal Analysis
• A base year is selected and the changes overtime
  are expressed as percentage of the base year

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Example trend analysis
Fegas AS - Comparative Income Statements-TL
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Vertical Analysis of the Income Statements
Fegas A.S
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Horizontal Analysis of the Income Statement
Fegas A.S
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Vertical and Horizontal Analyses- Balance Sheet
Fegas A.S-Assets
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Vertical and Horizontal Analyses- Balance Sheet
Fegas A.S- Liabilities and Shareholders Equity
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Ratio Analysis

• Important point to be selective-too many ratios
  would lead to information overload
• Understand the meaning and limitations of the
  ratios
• Define the following elements before starting
• The viewpoint taken
• The objectives of the analysis
• The potential standards of comparison
• Remember ratios are not absolute they are
  relative performances over time, over a number
  of companies, over an industry, etc.
• Ratios might indicate changes in patterns and
  help to assess future risk of the company in
  question

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Usefulness of Ratios

• Help compare different firms, and
• Help compare the firm against its past
  performance
• Standards against which to compare ratios
• 1. The planned ratio for the period
• 2. The corresponding ratio from a prior period
• 3. The corresponding ratio for another firm in
  the same industry
• 4. The average ratio for other firms in the same
  industry

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Viewpoints taken

• Managers
• Responsible for day to day operations and and
  long-range performance
• Responsible and accountable for efficiency,
  effective deployment of capital, human resource
  and other resource management
• Owners
• Interested in current and long-term returns on
  their investments
• Expect growing earnings, dividends
• Affected by how earnings are distributed and how
  their shares are valued in the market
• Lenders and creditors
• Concerned about liquidity and cash flow of the
  company
• Interested in the degree of financial leverage
  employed
• Others employees, government, society

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Ratio Analysis

• liquidity ratios
• capital structure ratios
• profitability ratios
• market ratios

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Short-term Liquidity Measures

• current ratio
• quick ratio or acid test
• cash flow from operations to current liabilities
  ratio
• working capital to assets ratio
• working capital turnover
• accounts receivable turnover
• inventory turnover
• accounts payable turnover

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current ratio
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quick ratio or acid test
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cash flow from operations to current liabilities
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net working capital to total assets
Net Working Capital Current Assets Current
Liabilities
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working capital turnover ratio
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accounts receivable turnover
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inventory turnover
Days Supply in Inventory 365 / Inventory
Turnover
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accounts payable turnover
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Capital Structure Ratios

• show how the assets of a company are financed
  i.e. through debt or equity, and provide
  information about the long-term liquidity of a
  company
• debt ratios
• equity measures
• cash flow from operations to total liabilities,
• number of times interest charges are covered

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Debt Ratios

• provide information about the financial leverage
  of a company

long-term debt ratio(LTDR)
debt to equity
debt ratio
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Equity Measures

• assuming there are 25.000 shares outstanding at
  the end of 2003 and 2004, the book value per
  share is TL 2,94 (TL 73.620 / 25.000 shares) and
  TL 2,97 (TL 74.280 / 25.000shares) in 2003 and
  2004 respectively

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cash flow from operations to total liabilities

• shows how well a company generates cash from its
  operations to meet its investment needs and
  obligations to pay its short- and long-term debt

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times interest earned

• more important for the long-term creditors
• shows how well the interest expense is covered by
  the earnings
• indicates the relative protection of bondholders
  and assesses the probability of bankruptcy due to
  failure in meeting the payments

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Profitability Ratios

• These ratios show how well a company utilized its
  resources to generate revenues in a given period
• Return-on-equity
• Return-on-assets
• Earnings per share
• Profit margin

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Return of Return

• Indicates the return that accrues to common
  stockholders after the interest payments and
  dividends to preferred stockholders

• measures the profitability of total resources
  available to the business
• indicates the efficiency with which management
  used the total available resources to earn
  income

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ROE and ROA example
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Financial Leverage Effect

• Shows whether borrowing was/is beneficial to the
  shareholders

Financial Leverage Effect ROE - ROA
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earnings per share (EPS)

• amount of earnings per common share after
  preferred stock dividends and reserves are
  deducted from net income
• Weighted average number of common stock
  outstanding refers to the number of shares that
  were issued and outstanding during the year

assume Fegas AS had 20.000 shares outstanding
before issuing 5.000 new shares in 2003 and the
weighted average number of shares was 21.000 in
2003
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Gross margin or gross profit ratio

• indicates whether a company has generated enough
  profit from sales to cover its other expenses and
  also to provide an adequate return to the
  investors

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Market Ratios

• price earnings ratio
• price to book ratio
• dividend payout ratio

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price earnings ratio (P/E ratio)

• gives the number of times EPS that investors are
  willing to pay for one share of stock

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price to book ratio (P/B ratio)

• gives the expectations of the market regarding
  the returns on a specific stock

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dividend payout ratio

• measures the proportion of income paid out in
  dividends

Dividend Payout Ratio Dividends / Net Income
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dividend yield

• the ratio of annual dividends to the current
  market share price
• usually mature companies tend to have higher
  yields than the growing or young companies

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Uses and Interpretation of Ratio Analysis

• Comparison of current year ratios with those of
  preceding years
• Comparison of actual ratios with the budgeted or
  standard ratios developed by the company
• Comparison of the ratios with those of the
  competitors
• Comparison of ratios for the industry in which
  the company operates

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Limitation of Ratio Analysis

• Represent the average conditions and influenced
  by the accounting methods used
• Based on historical data and do not reflect price
  level effects and real economic values
• Changes in many ratios are strongly associated
  with each other and interrelationships
  among/between the ratios should be examined
• During comparison of ratios over a period of time
  changes in operating conditions should be taken
  into consideration
• During comparison between companies differences
  among the companies should be examined
• Use audited financial statements to perform ratio
  analysis

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Its the information that counts, not the
numbers? Right?