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The objectives of this module are to present some of the fundamentals of financial statement analysis to afford the non-accountant a very basic understanding of how the investor and analysts use financial statements in making investment decisions and what should be necessary for the company to report to the regulator in order to provide the investor with the information needed

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MODULE 9

ANALYZING THE FINANCIAL STATEMENTS

The views expressed in this paper are the views of the authors and do not necessarily

reflect the views or policies of the Asian Development Bank (ADB), or its Board of

Directors or the governments they represent. ADB makes no representation

concerning and does not guarantee the source, originality, accuracy, completeness or

reliability of any statement, information, data, finding, interpretation, advice, opinion, or

view presented.

Learning Objectives:

The objectives of this module are to present some

of the fundamentals of financial statement analysis

to afford the non-accountant a very basic

understanding of how the investor and analysts use

financial statements in making investment

decisions and what should be necessary for the

company to report to the regulator in order to

provide the investor with the information needed.

CONTENTS

Page

I

Ratios

3

Profitability

3

Rate of Return

3

Return on Investment (ROI)

4

Return on Equity (ROE)

5

Dividend

Yield

6

Dividend

Payout

Ratio

7

Liquidity

7

Working Capital

7

Current Ratio

8

Acid

Test

Ratio

/

Quick

Ratio

8

Activity

8

Turnover

9

Days’ Sales in Accounts Receivable and

Days’ Sales in Inventory

10

Leverage

11

Debt Ratio and Debt/Equity Ratio

12

Times

Interest

Earned

Ratio

13

1

II Trend

Analysis 13

Secular

Trends 14

Cyclical

Trends 15

Linear

Trends

16

Moving

Average

17

2

The learner might consider printing out each financial statement from

Module eight so that he or she may refer to it as the elements of each are

discussed. For this reason, each is displayed on a single screen. The

learner is encouraged to review the information in Module eight before

beginning this Module.

describe very much about the company. When these ratios are compared over time, a

trend will emerge which will indicate the direction that these ratios are taking and when

ratios are compared over time the process is known as

investors use ratios and trend analysis as tools to interpret and evaluate the figures on a

financial statement.

Of course, consistency in financial reporting and in defining the ratio components is

crucial if either the ratio or the trend is to be meaningful.

The ratios and trends that are calculated can be categorized under the four areas of

profitability, liquidity, activity and leverage.

PROFITABILITY

Three of the most important measures of profitability are the return on investment (ROI)

and return on equity (ROE). Each of these measures, derived from the income

statement, relates net income to an element on the balance sheet.

RATE

OF

RETURN

Investors look at the

and to compare potential investments. If investment A is paying a return of $80 and

investment B is paying a return of $90, which investment should you buy? The answer

is not as easy as it may first appear. The amount of the return is not enough information

to make an informed decision. You also need to know how much each investment cost

and what is the time period that the investment takes to yield that return. If we assume

an annual rate of return, the formula for the rate of return is:

The rate of return is calculated by dividing the amount of the return by the amount of the

investment. If the cost of the investment for each of the two options above is the same,

then investment B has the higher rate of return. For example, if both cost $1,000, then

3

the amount of the return ($80for A, $90 for B) divided by the amount invested ($1,000)

would yield a return of 8% for A ($80 / $1,000) and 9% for B ($90 / $1,000)..

If the costs of the investments are different, the return on the investment must be

calculated. If investment A above costs $1,000, but investment B above costs $500 then

the amount of return of B ($90 divided by $500) would be 18% and the better

investment.

RETURN ON INVESTMENT

The return on investment (ROI) is used as an indication of the effectiveness of

management since it describes the rate of return that management was able to achieve

on the assets that it had available to use in operating the business. Before we get to

ROI, let’s first look at the rate of return. The return on investment (ROI) is the name for

the rate of return on the assets for a company and can be expressed by the formula:

The income statement of ATC in Module eight reported that the net income was $18,000

and the total assets from the balance sheet were $284,000. An average of the total

assets for the current year and the total assets for the previous year is used after the

company’s first year of operation because the net income was earned over that one-year

period and therefore should relate to that one-year period. For ATC, the ROI was

approximately 6.3% ($18,000/$284,000).

If we assume that ATC had been in business the previous year and that the total assets

for that year were $194,000, the average total assets would be $239,000 ($194,000 plus

$284,000 divided by 2). The ROI in that case would be approximately 7.5% ($18,000 /

$239,000).

As mentioned in Module eight, the standards of accounting are not a codified set of rules

to be blindly followed. In accounting, consistency in the definition of terms is more

important than the definition itself. So it should come as no surprise that the above ROI

formula is not the only ROI formula that can be used.

The balance sheet element in the formula is average total assets. By now you should

have developed a healthy skepticism about the assumptions, methods and calculations

of these “average” amounts and how they relate, or don’t relate, to “true” rates of returns

based upon real economic profit and fair market values. Therefore, actual rates are

usually used instead of averages and again, the raw ratios are not as important as the

trend of these ratios.

Some financial analysts will use operating income and average operating assets in the

formula because they believe that excluding interest expense, income taxes, and assets

not used in operating the business results in a better measurement of the operating

results. That formula would be:

4

Another popular approach to ROI is known as the DuPont model, because it was

developed by the financial analysts at E.I. DuPont de Nemours & Co. a large chemical

company in the Untied States. The significance of the DuPont model is that it has led

many managements to consider utilization of assets, including keeping investment in

asserts as low as feasible to be just as important to overall performance as generating

profit from sales. That formula is:

Net income divided by sales is also called margin. Margin emphasizes that a portion of

every cash unit of sales revenue must appear in net income.

Sales divided by average total assets is asset turnover or turnover. Turnover relates to

the efficiency with which the company’s assets are used in generating revenue.

Therefore:

RETURN

ON

EQUITY

Return on Equity (ROE) is the primary measure of a company’s profitability. It is the

percentage of net income divided by average owners’ equity for the fiscal period in which

the net income was earned.

As with the formula for ROI, operating income, which excludes other income and

expense (mainly interest expense) and income taxes, is also frequently used in

calculating ROE because it is a more direct measure of the results of management’s

activities than is net income. Interest expense (included in net income) is a function of

the board of director’s decision about capital structure (debt and owner’s equity) and not

a function of the operating activities of the company. Income taxes are a function of the

tax laws and therefore also not under the control of management.

The other three most common profitability ratios are the P/E, dividend yield and the

dividend payout ratios.

5

We previously discussed the price/earnings (P/E) ratio and said that is was:

P/E = price of a share of stock / earnings per share

The denominator of this equation is used extensively by investors and market analysts to

evaluate the market price of a stock against the market price as a whole. The P/E ratio

(or P/E) is also known as the

that the market price of a stock is equal to the earnings per share multiplied by the P/E

ratio.

The P/E ratio, or earnings multiple, is one of the most important measures used by

investors and analysts to evaluate the market price of a share of common stock.

When the decision to buy a share of common stock is made, it is most often based upon

the fact that the buyer anticipates the company will pay dividends (usually cash but

maybe stock) based upon profits and the price of the stock will rise. So, in a very real

sense, the market price of a share of common stock is a reflection of investor

expectations of dividends. The greater the probability of increased earnings, the more

investors are willing to pay for the stock. For example, company A is trading at

HK$48.00 and company B is trading at HK$75.00. Which is the better investment? One

might be tempted to say company B because the stock is trading at a higher price and

therefore, it would be assumed, that company B is worth more than company A.

However, suppose we also knew that company A’s last quarter earnings per share were

HK$4.00 and company B’s last quarters earnings per share were HK$7.50. Now which

is the better investment? It still may look to some that company B is the better

investment due to higher price and higher earnings. Now, calculate the P/E ratio. Which

is the better investment? (Answer appears in the answers to the questions at the end of

this Module).

As your calculations reveal, investor’s are willing to pay more for the stock of company A

than for the stock of company B, because investors expect better future earnings and

growth from company A than they do from company B. This is the reason that stock

tables publish the P/E ratio. High P/E ratios indicate high investor expectations, low

multiples indicate low expectations.

Analysts will also use the expected earnings of a company and the current market price

to determine the future market price of a company’s stock. Other approaches are to use

the expected future earnings per share and the current (or expected future) earnings

multiple.

DIVIDEND YIELD

Another ratio used by investors and analysts is the dividend yield:

evaluate the extent to which the investment objectives are being met.

6

DIVIDEND PAYOUT RATIO

Another ratio involving the dividend is the dividend payout ratio which reflects the

company’s dividend policy is the dividend pay-out ratio.

percentage. Knowing the dividend pay-out ratio permits the investor and analyst to

project future dividends from projected earnings as well as track the company’s ability to

earn profits consistently enough to pay or increase the dividend pay-out target. Again, a

trend here is more important than one static figure.

LIQUIDITY

Liquidity is the company’s ability to meet its current obligations. There are three

principal tests of liquidity. The figures are obtained from the balance sheet.

*cash includes temporary cash investments

The acid test ratio is also known as the

because merchandise inventories are excluded from the computation. This is the ability

of the company to meet its current obligations without selling any of its inventory.

Working capital is not as significant as the current ratio and as we said earlier, it is the

trend of this ratio that is the most important information. The working capital

measurement merely reports a figure, without a reference this figure is not very

meaningful. If working capital is HK$3.2million, what does that tell you?

From the balance sheet of ATC set forth in Module eight, we found that the current

assets are $284,000 and the current liabilities are $67,000. Therefore, working capital is

$217,000 ($284,000-$67,000). Is that good or bad? Is our company liquid? How can

you tell?

7

The current ratio is 4.2 ($284,000/$67,000) and the acid test ratio is 1.7. As a general

rule,

good liquidity.

You will recall that it was stated in Module eight that the accounting standards were not

detailed proscriptions but rather general guidelines for operation that left choices in

assumptions, methods and calculations up to the accountant. Financial statement

analysis involves careful observation of those assumptions made by the accountant and

the methods chosen to account for the reporting. The analysis attempts an

understanding of the basis for the assumptions and methods used to acquire the figures

reported. It further attempts to work those figures into ratios that may be compared to

reveal relative standing and to discern trends in those ratios to determine direction of the

figures, the future of the company and therefore the direction of the stock price.

For example, let’s look at the effect of the inventory cost-flow assumption on the working

capital ratio. The value of inventory that is reported on the balance sheet will depend on

whether the weighted-average, FIFO (first in, first out), or LIFO (last in, first out)

assumption is used. In periods of rising prices, a company using FIFO will report a

relatively higher asset value for inventories than a similar firm using the LIFO cost-flow

assumption. Therefore, even though two companies may be similar in all other respects,

they will report different amounts of working capital and they will have a different current

ratio. Without analyzing the assumptions, the reader of the financial reports for these

two companies would not know that a direct comparison of current ratios cannot be

made because of the different inventory accounting methods used. The better

comparison to be made for these two companies would be the trend of the two ratios.

ACTIVITY

Physical measures of activity, rather than financial measures, are also frequently used.

For example, it may be more informative to know the number of units sold rather than

the sales value of those units. The amount will reflect inflation, deflation and currency

changes, unit numbers will not. The same is true for reporting the total number of

employees rather than the payroll costs of a company.

Many analysts combine the physical and financial measures to develop useful statistics

and plot trends in order to compare results over time of a company or the differences

between companies. Sales values per employee and operating income per employee

may be used as productivity measures. Plant operating expenses per square foot or

gross profit per square foot might also be used as a productivity measure.

When comparing the operating results of different sized companies, many analysts

convert the items on the balance sheets into percentages of total assets and the items

on the income statement into percentage of sales. This process results in

financial statements.

As is the case with the accounting standards themselves, there are no absolutes in

measurements and analysis. The goal is to look behind the figures and determine the

company’s objectives, procedures and methods and to develop measurements that are

meaningful when used in comparison with each other within the company, between

8

companies and across sectors. It is often the case, that the trend of a ratio is more

informative than any single ratio.

TURNOVER

Activity measures the efficiency with which assets have been utilized to generate sales

revenue. Therefore, activity measures focus primarily on the relationship between asset

levels and sales (called

Remember that we said that financial statements were a snapshot of the financial

condition of a company at a given point in time. Because sales are generated over a

period of time, it is appropriate that the average asset investment over the same period

be used rather than the amount of assets at any single point in time, such as the balance

sheet amount reported at the end of a fiscal period.

Usually the average asset amount is determined by using the balance sheet amount

reported at the beginning and end of the period. However, if available, monthly and

quarterly balance sheet amounts can be used to calculate an average.

Turnover is usually calculated for:

Accounts receivable;

Inventories; and

Plant and equipment;

*because inventories are reported at cost, it is possible to substitute the

cost of goods sold for the sales amount in the turnover formula.

**some analysts use the cost of plant and equipment rather than the net

book value (cost minus accumulated depreciation) when calculating plant

and equipment turnover. This removes the differences in depreciation

calculation methods. However, since the assets or each company are

reported at original cost and not current value or replacement cost, as

they are acquired over time, the cost data are not as likely to be

comparable.

9

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