FINANCIAL STATEMENTS ANALYSIS Financial statement analysis is the process by which the relationships, changes and trends are

determined from data in the financial statements and related information to arrive at an evaluation and conclusion as to the causes of changes and as to the soundness of the financial position and the results of operations of an enterprise. It involves the calculation of various percentages and ratios. It is used by interested parties as creditors, investors, and managers to determine the firms financial position relative to that of others. There are at least four traditional techniques of analyzing financial statements, namely: 1. Horizontal or comparative analysis presents the differences in amount and in percentage between two compared variables such as two periods, two companies, actual and budgeted, and other bases. The percentage change is computed as the amount of change or difference over the base. The base may be the last years data, budgeted data, average industry data, or chief competitors data. The percentage is not computed if the denominator is zero or negative. Example: Net sales Cost of sales Gross profit Operating Expenses EBIT 2010 P 570,000 200,000 P 370,000 100,000 P 270,000 2009 P 680,000 170,000 P 510,000 210,000 P 300,000 Inc. (Dec.) (110,000) 30,000 (140,000) (110,000) (30,000) % Inc.(Dec.) (16.2) 17.6 (27.5) (52.4) (10.0)

Interpretation: The net income decreased by 30,000 due to a 100,000 decrease in sales, 30,000 increase in cost of sales, and 110,000 decrease in operating expenses. Gross profit declined 27.5 percent due to the combined effects of lower sales and higher cost of sales. However, operating expenses were sharply cut. This kept the decline in net income to only 10 percent. 2. Trend analysis extends beyond two years. Trend analysis uses indexes and ratios to simplify the visible complications of numbers contained in the financial reports. Indexes are expressed in hundreds while ratios are expresses in normal decimal places. The base year (100%) is normally the earliest year; however, the choice of the base year is purely judgmental. Example: Current liabilities Non-current liabilities Current liabilities Non-current liabilities 2010 P 34,000 P 60,000 2010 170% 120% 2009 P 25,000 P 45,000 2009 125% 90% 2008 P 20,000 P 50,000 2008 100% 100%

3. Vertical or common-size analysis gets the proportional component of each of the variables in the financial statements in relation to a chosen base. The base in the income statement is the net sales; the base in the statement of financial position is the total assets or total equity. In the statement of cash flows, the base may be the total cash available for use. By expressing the financial data in percentage using a particular base, the size of different companies is brought to a common expression. Example: Net sales Cost of sales Gross profit Operating Expenses EBIT 2010 P 400,000 280,000 P 120,000 75,000 P 45,000 % 100 70 30 18.8 11.2 2009 P 250,000 160,000 P 90,000 56,000 P 34,000 % 100 64 36 22.4 13.6

Interpretation: Cost of goods sold may have increased because of higher costs in buying merchandise. Expenses may have dropped due to better cost control. However, the drop in expenses has not offset the rise in the cost of goods sold and so the companys profits have declined from 2009 to 2010.

4. Financial ratios Since the financial statements are fundamentally-related, we also have to relate information contained in one statement with the related information found in another. This is called interfinancial statements analysis. There are several classifications of financial mix ratios: profitability ratios, growth ratios, liquidity ratios, activity ratios, and leverage ratios.

Ratios PROFITABILITY RATIOS Return on sales (also, net profit rate and profit margin) Gross profit rate

Formula

Comments

Net income / Net sales Gross profit / Net sales

Measures profit percentage per peso sales Measures gross profit percentage on sales to recover operating expenses Determines the rate of return on every peso of investment in a project or business Measures overall asset profitability; indicates how effective assets have been employed by management Percentage of income derived for every peso of owners equity Percentage of profit derived for every peso of common equity money used Measures the number of times profit will increase of decrease in relation to changes in net sales Measures the adequacy of current earnings to meet preferred dividend payments Measures the rate of earnings per share of common stock

Return on investment

Net income / Average total assets

Return on total assets

Net income + interest expense, net of tax / Average total assets

Return on stockholders equity

Net income / Average stockholders equity Earnings available to common stockholders / Average common stockholders equity Contribution margin / Net income

Return on common stockholders equity

Operating leverage

Times preferred dividends earned

Net income / Preferred dividend requirements

Earnings per share

(Net income Pref. dividends) / Average common shares outstanding

LIQUIDITY RATIOS Current asset ratio Current asset / Current liabilities Measures the ability if the business to meet its currently maturing obligations Measures the ability if the business to meet its currently maturing obligations using quick assets (cash, m. securities, receivables) Indicates the amount invested by the business to operate its normal business activities Measures the ability if the business to meet its currently maturing obligations using cash

Quick asset ratio or Acid-test ratio

Quick assets / Current liabilities

Net working capital

Current assets Current liabilities

Cash ratio

Cash + Marketable securities / Current liabilities

ASSET MANAGEMENT AND ACTIVITY RATIOS Inventory turnover Cost of goods sold / Average inventory Number of times inventories were acquired or produced and sold during the period Length of time spent before the average inventory is sold to customers Measures the efficiency in credit and collection policies Measures the average number of days to collect a receivable Average number of days to convert inventories to cash Measure the effectiveness in using trade credit facility from supplier Number of days spent before paying liabilities to merchandise suppliers Indicates the number of days cash is short or over Measures the level of use of property, plant and equipment Level of capital investment relative to sales volume; effectiveness of asset utilization Measures the percentage of net income available for investment

Inventory turnover in days

360 days / inventory turnover

Accounts receivable turnover

Net credit sales / average accounts receivable 360 days / accounts receivable turnover Inventory turnover in days + accounts receivable in days Net credit purchases / average trade payables 360 days / accounts payable turnover

Receivables turnover in days or collection period Operating cycle

Accounts payable turnover

Payable payment in days

Cash cycle or net cash cycle

Operating cycle payable payment in days Net sales / average fixed assets Net sales / average total assets

Fixed asset turnover ratio

Total assets turnover

Plowback ratio

Amount available for reinvestment / net income

LEVERAGE RATIOS Equity multiplier Average total assets / average common equity EBIT / EBIT interest expense preferred dividend (before tax) Total liabilities / total assets Measures the percentage of funds provided by creditors Compare resources provided by creditors with resources provided by shareholders Indicates the margin of safety for payment of fixed interest charges Ability to meet interest payments Ability to meet non-current assets using non-current liabilities Number of times owners equity is multiplied

Financial leverage

Debt ratio

Debt to equity ratio

Total liabilities / equity

Times interest earned

EBIT / interest expense

Total assets to total liabilities Non-current asset to long term liabilities ratio

Total assets / total liabilities Non-current assets / non-current liabilities

GROWTH AND VALUATION RATIOS Basic earnings per share Earnings to common stockholders/ weighted average common shares Earnings per share / market price per share Reflects the companys earning power; ability to generate income Shows the relationship of earnings per share to the market price per share Number of years investment in stock will be recovered Shows whether a firm pays out most of its earnings in dividends or reinvests the earnings internally Measures the rate of cash return to investment in stock Indicates the value of the stock on cost perspective

Earnings yield

Price-earnings ratio

Market price per share / earnings per share Cash dividends per share / earnings per share

Dividend payout ratio

Dividend yield

Cash dividends per share / market price per common share Stockholders equity / average shares outstanding

Book value per share

ILLUSTRATION: The following data have been gathered from Bumblebee Companys records and industry published reports (in thousands of pesos): 2010 50,000 30,000 20,000 4,200 15,800 800 15,000 4,500 10,500 2010 5,000 40,000 30,000 75,000 75,000 150,000 20,000 70,000 60,000 150,000 2009 40,000 26,000 14,000 4,500 9,500 500 9,000 2,700 6,300 2009 10,000 30,000 20,000 60,000 40,000 100,000 15,000 40,000 45,000 100,000

Net sales Cost of sales Gross profit Operating expenses Earnings before interest and taxes Interest expense Earnings before taxes Income tax Net income

Cash Accounts receivable Inventory Total current assets Non-current assets Total assets Current liabilities Non-current liabilities Stockholders equity Total Equity Other information: Market price per common share Dividend per common share Common shares outstanding

10.0 / sh. 2.5 / sh. 3,000,000

7.0 / sh. 1.0 / sh. 3,000,000

Required: Make a comprehensive analysis of the financial records using the traditional techniques discussed.