Basic-Ratio Analysis

Ratio Analysis Conducted by WasimullahFinancial Statement Analysis(FSA)LECTURE OBJECTIVES1)Explain GAAP & development of accounting rules 2)Discuss components of Annual Reports3)Explain objectives of financial statement analysis (FSA)4)Examine key analytical techniquesVertical & Horizontal AnalysisRatio analysisExplain other analysis tools5)Discuss key issues in FSA1. FINANCIAL STATEMENTS &Generally Accepted Accounting PrinciplesThe rules, standards & usual practices that accountants are expected to follow in preparing financial statementsComprises:Traditional assumptions & principlesProfessional & statutory rulesA Conceptual FrameworkTraditional Assumptions & PrinciplesThe entity conceptThe recognition & matching principlesThe reliability or objectivity conceptThe materiality conceptThe conservatism principleThe (historical) cost principleThe stable-monetary-unit conceptProfessional RulesInstitute of CharteredAccountants (ICAP)ACMA &Other BodiesSECPIssues Standards & Guidelinesapplicable to membersSecurities & Exchange Commission Of PakistanStatutory RulesFederal/State GovernmentCorporations LawAustralian AccountingStandards Board (AASB)Issues accounting standards for companies (AASBs)Comprises reps. from:•Professional Bodies•ASX•Business Groups•S’holders’ Assoc.•Government International Accounting Standards (IAS)•Issued by the International Accounting Standard Setting Committee (IASC)(Based in London) •IASs are becoming the benchmarkfor global accounting–Many countries adopt IASs in full or in modified form or are harmonising their own standards with IASs –Many stock exchanges accept financial statements based on IASs & this will increase with the recent release of a revise set of IASs–e.g the ASX accepts reports by listed foreign companies prepared under IASsThe Conceptual Framework (CF)International standard setters are increasing relying a conceptual frameworkA CF is a set of interrelated concepts that define the nature, purpose and broad content of general purpose financial reportingIs used as a basis for attempts to harmonize international accounting standardsThe CF & Financial Statements•The CF has had a major impact of the accounting standards and information presented in financial statements•It is used as a basis for attempts to harmonizeinternational accounting standards•Should ultimately provide benefits to investors, creditors and other users of financial statement in interpreting and comparing financial information The CF & Financial StatementsConceptual FrameworkConcepts & PrinciplesAccounting StandardsFinancial StatementsWhere no acctg. std. exist2. ITEMS IN AN ANNUAL REPORT3 FINANCIAL STATEMENTSCurrent & Comparative YearFOOTNOTES TO FINANCIAL STATEMENTSSUMMARY OF ACCOUNTING POLICIESDIRECTORS’ REPORT/MD&A STATEMENTAUDITOR’S REPORT123456SELECTED SUMMARY DATA e.g. 5-year Ratio Analysis3. OBJECTIVES OF FINANCIAL STATEMENT ANALYSISInvestors, creditors & other users use financial statement analysis in decision-making to: (1) measure financial position(2) measure performance & predicting returns(3) assess financing & investing activities(4) assess financial & operating risk (5) check compliance & accountability4. ANALYTICAL TECHNIQUESHorizontal (trend) analysis Vertical analysisRatio analysis3 common categories:Horizontal (Trend) AnalysisAnalysis of % change in financial statement items over years Used to identify the causeof change, whether favourable or not, & whether the trend is likely to continue Vertical AnalysisRelates a specific item in the fin. statements to a related item on the same statemente.g. COGS to SalesProduces Common Size Statementsi.e. each item in the financial statements is presented as a % of the common base amount Used to compare firms which differ greatly in terms of size of operations. Ratio AnalysisRelates one financial statement item amount to another Allows the analysis of important indicators of financial performance & positionRatios are an aidto analysis that can provide directions or trends when compared with:1. A company’s own historical ratios2. General rules of thumb3. Other companies’ and industry averagesRatio AnalysisRatios can be calculated in different wayse.g trend, vertical and horizontal analysisAlso, depending on the purpose of the analysis can use either–Average bases(denominators) -to assess long run performance–End of year bases-to highlight changes from year to yearMajor Ratio GroupsA)LIQUIDITY RATIOSB) LEVERAGE RATIOSC) ACTIVITY RATIOSD) PROFITABILITY RATIOS(A) (Short-term) Liquidity RatiosMeasure the ability to meet short-term financial obligations from readily available cash resourcesFocuses on working capital (current assets -current liabilities)Key ratios:Current RatioQuick (Acid test) RatioCurrent AssetsCurrent LiabilitiesCash + Marketable Sec. + ARCurrent Liabilities==Norm>2:1Norm>1:1Note Average Collection Period & Inventory T/O ratios can also be included in this category(B) Leverage (Long-term Solvency) RatiosMeasure the extent of debt usage and the ability of the company to meet debt obligationsBased on capital structure, the relevant mix of debt to equity & financial risk implied Key ratios:Debt-to-EquityTotal Liabilities Total S’holders EquityDebt-to-AssetsTotal LiabilitiesTotal AssetsIncome b/Interest &TaxInterest Expense*Interest Coverage===*Borrowing costsNorm 50-60%Norm < 100%Norm > 2:1(C) Activity RatiosUsed to measure the level of asset commitment and the degree of asset usageKey ratios:Inventory TurnoverCOGS . InventoryAverage Collection PeriodFixed Asset Turnover Accounts Receivable SalesSales Fixed Assets===Total Asset TurnoverSales Total Assets=X 365Can Use Average BasesSales Inventory(D) Profitability RatiosMeasure the ability of the company to turn sales into profits & earn profits on assets committedKey ratios:Return on Assets(ROA)Operating Profit (Pre-Interest)Average Total AssetsReturn on S’holders’Funds (ROE)Operating Profit Margin Net Income Average S’holders EquityOperating Profit (Pre-tax &Interest)Sales===Net Profit Margin (Return on Sales -ROS)Net IncomeSales=EBITLess Pref. dividendsDu Pont ModelTotal AssetTurnoverOperating ProfitMarginReturn onAssetsTaxes & Other‘Leakages’FinancialLeverageReturn on Shareholders’EquityProvides a structured method of analysing ratios (& factors) contributing to the change in ROESales GrowthGross ProfitExpense ManagementFixed Asset TurnoverInventory TurnoverDays Receivables OutstandingAdditional Analysis ToolsMarket Ratios: Used explicitly or implicitly in valuing shares Key ratios:Earnings Per Share(EPS)Net Income (b/Extra. Items)Ave. no. of Ordinary SharesPrice Earnings Ratio (PE Ratio)Dividend YieldMarket Share PriceEPSDividends per Share (DPS)Market Share Price===Dividend PayoutDPSEPS=Ratios in Valuation ModelsSimple Valuation Model: Vi = Ei/keFor example:Assume a constant earnings (Ei) of $200 m per year & the cost of capital (ke) is 12% (i.e. risk adjusted required return to equity holders) Then value (Vi) of the firm is simply:Vi= Ei/keVi= 200/.12= $1,670 mKey Points from the Valuation ModelValue depends on:Management of current operating performance and growthSales, Profit, etc.Management of capital structure Including risks and returnsManagement of investment in growth opportunitiesIncluding market conditions, market share, strategic position5. KEY ISSUES IN FSA(1) Changes/differences in accounting methods can lead to very different income & balance sheet numbers For exampleAlternative methods of depreciation, inventory measurement, asset valuation, etc.Unrecorded, under-recorded assets & liabilitiesImpact of Abnormal & Extraordinary itemsAre they transitory or permanent? Auditor opinion/qualification may indicate incorrect accounting practicesKey Issues In FSA(2) Cross-sectional AnalysisCompanies may not be comparable due to differences in:sizefinancingindustryriskKey Issues In FSA(3) Time-series AnalysisNeed to control for the effects of inflation mergers and takeoversreconstructions'Big Bath' phenomenoni.e. historical relationships that may not continueor be typical