# Analyzing Financial Data and Ratios HKIAAT

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```					Analyzing Financial Data and
Ratios

Mr. Michael Wong
Lecturer, PolyU HKCC
Value of Financial Statement
Analysis
   Financial statements, by their nature, are backward-
looking
   So why analyze the statements?
   Analysis provides knowledge of a firm’s operating and
financial structure
   This aids in estimating future returns
Major Financial Statements
   Corporate annual reports must include:
   Statement of Financial Position
   Income statement
   Statement of cash flows
   Enough for analysis?
Purpose of Financial Statement
Analysis
   Evaluate management performance in
   Profitability
   Efficiency
   Risk
   Although financial statement information is
historical, it is used to project future
performance
Five Categories of Financial Ratios
1.   Common size statements
2.   Internal liquidity (solvency)
3.   Operating performance
   Operating profitability
   Operating efficiency
4.   Risk analysis
   Financial risk
5.   Growth analysis
Common Size Statements
   Normalize balance sheets and income statement
items to allow easier comparison of different size
firms
   A common size balance sheet expresses accounts as
a percentage of total assets
   A common size income statement expresses all items
as a percentage of sales
Consolidated
Statement of
Income
Consolidated
Statement of
Financial
Position
Evaluating Internal Liquidity
   Internal liquidity (solvency) ratios indicate the
ability to meet future short-term financial
obligations
   Current Ratio
   Quick Ratio
   Cash Ratio
Evaluating Operating Performance
   Ratios that measure how well management is
   Operating profitability ratios
   Examine how management is doing at controlling
costs so that a large proportion of the sales dollar is
converted into profit
   Operating efficiency ratios
   Examine how management uses its assets to generate
sales; considers the relationship between various asset
categories and sales
Operating Profitability Ratios
   Operating profitability
ratios measure
   Gross profit margin
   Operating profit margin
   Net profit margin
   Return on owner’s
equity (ROE)
Operating Efficiency Ratios
   How effectiveness of a firm’s use of its total
asset base to produce sales
   Total asset turnover
   Non-current asset turnover
   Operating cycle
   Cash conversion cycle
Operating Cycle & Cash Conversion Cycle
Raw material
Cash
purchased                       Finished goods sold
Order   Stock
Placed Arrives

Inventory period               Accounts receivable period

Time
Accounts payable period

Firm receives invoice         Cash paid for materials
Operating cycle
Cash
conversion
cycle
Operating Profitability Ratios
    Return on owner’s equity (ROE) indicates the
rate of return earned on the capital provided
by the stockholders after paying for all other
capital used

Net Income
Return on Total Equity 
Average Total Equity
Operating Profitability Ratios
   The DuPont System divides ROE into several
ratios that collectively equal ROE while
individually providing insight
   An extended DuPont System provides
additional insights into the effect of financial
leverage on the firm and pinpoints the effect
of income taxes on ROE
Operating Profitability Ratios
Net Income

Common Equity

Net Income      Sales      Total Assets
                         
Sales      Total Assets Common Equity

Profit     Total Asset     Financial
=   Margin
x Turnover      x Leverage
Risk Analysis
   Risk analysis examines the uncertainty of income for
the firm and for an investor
   Total firm risks can be decomposed into two basic
sources:
   Business risk: The uncertainty in a firm’s operating
income, highly influenced by industry factors
   Financial risk: The added uncertainty in a firm’s net
income resulting from a firm’s financing decisions
 Variability of the firm’s operating income over time
Two primary determinants of business risk
 Sales variability
   The main determinant of earnings variability
   Cost Variability and Operating leverage
   Production has fixed and variable costs
   Greater fixed production costs cause greater profit
volatility with changes in sales
   Fixed costs represent operating leverage
   Greater operating leverage is good when sales are high
and increasing, but bad when sales fall
Effect of operating leverage
risk, for then a small sales decline causes a big
profit decline.
\$          Rev.   \$            Rev.
TC                 } Profit
TC
FC
FC
QBE     Sales       QBE     Sales

   What happens if variable costs change?
Financial Risk
   Interest payments are deducted before we get
to net income
   These are fixed obligations
   Similar to fixed production costs, these lead to
larger earnings during good times, and lower
   Fixed financing costs are called financial leverage
   The use of debt financing increases financial
risk and possibility of default
Financial Risk
   Two sets of financial ratios help measure
financial risk
   Balance sheet ratios
   Earnings or cash flow available to pay fixed
financial charges
   Acceptable levels of financial risk depend on
   A firm with considerable business risk should
likely avoid lots of debt financing
Financial Risk
   Balance Sheet Ratios
   Total debt ratio
   Debt-equity ratio
   Equity multiplier
   Earnings or cash flow available to pay fixed
financial charges
   Times interest earned ratio
   Cash coverage ratio
Potential Growth Analysis
   Important to both creditors and owners
   ability to pay future obligations
   Ability to pay dividends
g = ROE x Retention rate
   The retention rate is one minus the firm’s dividend
payout ratio
   Anything that impacts ROE would also be a
determinant of future growth
Importance of Relative Financial
Ratios
   In order to make sense of a ratio, we must compare it
with some appropriate benchmark or benchmarks
   Examine a firm’s performance relative to:
   The aggregate economy
   Its industry or industries
   Its major competitors within the industry
   Its own past performance (time-series analysis)
Comparing to the Aggregate
Economy
   Most firms are influenced by economic
expansions and contractions in the business
cycle
   Analysis helps you estimate the future
performance of the firm during subsequent
Comparing to the Industry Norms
   Most popular comparison
   Industries affect the firms within them differently,
but the relationship is always significant
   The industry effect is strongest for industries with
homogenous products
   Can also examine the industry’s performance relative
to aggregate economic activity
Comparing to the Firm’s Major
Competitors
   Industry averages may not be representative
   A firm may operate in several distinct industries
   Several approaches:
   Select a subset of competitors for the comparison group
   Construct a composite industry average from the different
industries in which the firm operates
Comparing to the Firm’s Own Past
Performance
   Determine whether it is progressing or
declining
   Helpful for estimating future performance
   Consider trends as well as averages over time
Other than financial statements
   Corporate Profile
   Chairman’s Statement
   Management Discussion and Analysis
   Notes to Financial Statements
   Segment information
   Noncurrent assets component
   Any commitments, etc.
   Government & Industry Statistics
Is financial performance everything?
management’s emphasis on short-run
financial performance
   Need to have some measures that translate an
organisation’s mission and strategy into a
comprehensive set of performance measures.
Other perspectives
   Four key perspectives:
1   Financial
2   Customer
4   Learning and growth
Other perspectives
   Because the non-financial and operational indicators
measure fundamental changes that a company is
making.
   The financial benefits of these fundamental changes
may not be captured in short-run earnings.
   Strong improvements in non-financial measures
signal the prospect of creating economic value in the
future.
Q&A
Summary of Ratio analysis

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 views: 4 posted: 9/24/2011 language: English pages: 34
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