Professional Documents
Culture Documents
Chapter 5 - Basics of Analysis
Chapter 5 - Basics of Analysis
Basics of
Analysis
_Financial Analysis_
Outline
• Ratio Analysis
• Common-size analysis
• Study of differences in components of financial statements among industries
• Review of descriptive material
• Comparisons of results with other types of data
The Users of Financial Statements
• Management
• Analyse information from the perspective of both investors and creditors
• Investors
• Analysis of past and present information to project the future prospects of the
entity
• Creditors
• Short-term: focus is on current resources
• Long-term: consider the future prospects of the firm
5.1. Ratio Analysis
• Liquidity
• Measures a firm’s ability to meet its current obligations
• Leverage (borrowing capacity)
• Measures the degree of protector for long-term creditors
• Profitability
• Measures the earning ability of a firm
• Investor-focused
• Cash flow
• Indicate liquidity, borrowing capacity, and profitability
Ratio Analysis
1. Ratios that reveal large deviations from the norm merely indicate the possibility of a
problem.
2. A single ratio does not generally provide sufficient information from which to judge
the overall performance of the firm.
3. The ratios being compared should be calculated using financial statements dated at
the same point in time during the year.
4. It is preferable to use audited financial statements.
5. The financial data being compared should have been developed in the same way.
6. Results can be distorted by inflation.
Ratio Analysis Example
• Liquidity Ratios
• Liquidity Ratios
• All three firms have current ratios of 1.3. However, the quick ratios for
Home Depot and Lowes are dramatically lower than their current ratios, but
for Dell the two ratios are nearly the same. Why?
Ratio Analysis (cont.)
• Activity Ratios
• Activity Ratios
• Activity Ratios
• Activity Ratios
• Activity Ratios
• Sell it fast
• Observe in Table 3.5 that the grocery business turns over assets faster than
any of the other industries listed.
• That makes sense because inventory is among the most valuable assets held
by these firms, and grocery stores have to sell baked goods, dairy products,
and produce quickly or throw them away when they spoil.
• On average, a grocery stores has to replace its entire inventory in just a few
days or weeks, and that contributes to the rapid turnover of the firms total
assets.
Table 3.6 Financial Statements
Associated with Patty’s Alternatives
Ratio Analysis (cont.)
• Debt Ratios
• Debt Ratios
Times interest earned ratio = EBIT ÷ taxes
• The figure for earnings before interest and taxes (EBIT) is the same as that for
operating profits shown in the income statement.
• Applying this ratio to Bartlett Company yields the following 2012 value:
$418,000 ÷ $93,000 = 4.5
Ratio Analysis (cont.)
• Debt Ratios
Fixed-Payment coverage Ratio (FPCR)
• Profitability Ratios
• Profitability Ratios
• Profitability Ratios
Net profit margin = Earnings available for common stockholders ÷ Sales
• Bartlett Company’s net profit margin for 2012 is:
$221,000 ÷ $3,074,000 = 0.072 = 7.2%
Ratio Analysis (cont.)
• Profitability Ratios
• Profitability Ratios
Return on total assets (ROA) = Earnings available for common stockholders ÷ Total assets
• Bartlett Company’s return on total assets in 2012 is:
$221,000 ÷ $3,597,000 = 0.061 = 6.1%
Ratio Analysis (cont.)
• Profitability Ratios
Return on Equity (ROE) = Earnings available for common stockholders ÷ Common stock equity
• This ratio for Bartlett Company in 2012 is:
$221,000 ÷ $1,754,000 = 0.126 = 12.6%
Ratio Analysis (cont.)
• Market Ratios
Price Earnings (P/E) Ratio = Market price per share of common stock ÷ Earnings
per share
• If Bartlett Company’s common stock at the end of 2012 was selling
at $32.25, using the EPS of $2.90, the P/E ratio at year-end 2012 is:
$32.25 ÷ $2.90 = 11.1
Ratio Analysis (cont.)
• Market Ratios
where,
Ratio Analysis (cont.)
•Substituting the appropriate values for Bartlett Company from its 2012 balance sheet, we get:
•Substituting Bartlett Company’s end of 2012 common stock price of $32.25 and its $23.00 book
value per share of common stock (calculated above) into the M/B ratio formula, we get:
$32.25 ÷ $23.00 = 1.40
Summary of Bartlett Company Ratios
Summary of Bartlett Company Ratios
5.2. Common-size analysis
• Horizontal analysis
• Amounts of comparative years are expressed as a percentage of the base year
amount
Vertical Analysis
Example
Example
Increase (Decrease)
2005 2004 Amount %
Assets
Current assets:
Cash $ 12,000 $ 23,500
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets 155,000 164,700
Property and equipment:
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment 160,000 125,000
Total assets $ 315,000 $ 289,700
Horizontal Analysis
Calculating Change in Dollar Amounts
The dollar
amounts for
2004 become
the “base” year
figures.
Horizontal Analysis
Calculating Change as a Percentage
Increase (Decrease)
2005 2004 Amount %
Assets
Current assets:
Cash $ 12,000 $ 23,500 $ (11,500) (48.9)
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets $12,000 –155,000
$23,500164,700
= $(11,500)
Property and equipment:
Land 40,000 40,000
($11,500
Buildings and equipment, net ÷ $23,500)
120,000 × 100% = 48.9%
85,000
Total property and equipment 160,000 125,000
Total assets $ 315,000 $ 289,700
Horizontal Analysis
CLOVER CORPORATION
Comparative Balance Sheets
December 31
Increase (Decrease)
2005 2004 Amount %
Assets
Current assets:
Cash $ 12,000 $ 23,500 $ (11,500) (48.9)
Accounts receivable, net 60,000 40,000 20,000 50.0
Inventory 80,000 100,000 (20,000) (20.0)
Prepaid expenses 3,000 1,200 1,800 150.0
Total current assets 155,000 164,700 (9,700) (5.9)
Property and equipment:
Land 40,000 40,000 - 0.0
Buildings and equipment, net 120,000 85,000 35,000 41.2
Total property and equipment 160,000 125,000 35,000 28.0
Total assets $ 315,000 $ 289,700 $ 25,300 8.7
5.3. Year-to-year Change Analysis
• Narrative data
• Annual report
• Trade periodicals
• Industry reviews
• Information
• Absolute: amplifies comparison difficulty
• Common-size: eliminates some of the difficulty