Financial Statement Analysis – Part 1 Notes

Lecture Topic 7: Financial Statement Analysis – Part 1

Learning Objectives

• Apply analytical methods of horizontal and vertical analysis.
• Apply ratio analysis methods.
• Define, calculate, and interpret profitability ratios.
• Define, calculate, and interpret asset efficiency ratios.
• Discuss the limitations of ratio analysis.

Textbook Readings

• Topic 7: Chapter 8, Sections 8.1 to 8.3 (Financial statement analysis, pages 292 – top of 308). Read up to the end of Asset Efficiency Analysis.

Topics Covered

• Introduction to Accounting & Business Environment
• Introduction to Statement of Financial Position & Recording Transactions Part 1
• Introduction to Statement of Profit & Loss, Cash Flow Statement Recording Transactions Part 2
• Statement of Profit & Loss, Accrual Accounting and Recording Transactions Part 3
• Analysis of Statement of Financial Position
• Statement of Cash Flows and Introduction to Financial Statement Analysis
• Financial Statement Analysis Part 1
• Financial Statement Analysis Part 2
• Budgeting
• Cost Accounting & pricing
• Performance Measurement & Sustainability

Introduction to Financial Statement Analysis

• Evaluating an entity’s financial past helps users form an opinion on its future financial health.
• Essential to compare figures to:
  • Equivalent figures from previous years.
  • Other figures in the financial statements.

Tools of Comparative Analysis

• Horizontal Analysis: Evaluates financial data over time.
• Vertical Analysis: Evaluates financial items in relation to a base amount; each item is expressed as a percentage of the base (“common size”).
• Ratio Analysis: Evaluates a range of financial relationships representing different aspects of an organization’s activities.

Analyzing Financial Statements

• Characteristics:
  • Profitability
  • Efficiency
  • Liquidity
  • Capital Structure
  • Market Performance
  • Cash
• Comparison Bases:
  • Intracompany
  • Industry averages
  • Intercompany
• Tools of Analysis:
  • Horizontal
  • Vertical
  • Ratio

Horizontal Analysis

• Used to evaluate financial statement data over a period.
• Compares reported numbers in different reporting periods to highlight the magnitude and significance of changes.
• Dollar change is calculated by: $Current period's number - Previous period's number$
• Percentage change is calculated by: $\frac{Current period's number - Previous period's number}{Previous period's number} × 100$

Horizontal Analysis - Example – JB Hi-Fi Ltd

• Asset Growth: Total assets increased by 2.3%, driven by a significant 13.4% rise in current assets, particularly in cash and short-term investments (+79.2%) and inventories (+5.1%).
• Liability Reduction: Total liabilities decreased by 3.5%, with current liabilities falling by 9.3%, notably in accounts payable (–12.0%) and deferred revenues (–8.9%).
• Equity Strengthening: Shareholders' equity grew by 10.9%, primarily due to a 16.9% increase in retained earnings, indicating strong profitability retention.

Trend Analysis

• Predicts the future direction of items based on their past direction.
• Requires at least three years of data.
• Expresses the item in subsequent years relative to a selected base year, usually given a value of 100.

Trend Analysis Example

• Converting sales revenue for a trend analysis:
  1. Set the base year (e.g., 2017) and assign it an index value of 100.
  2. Divide the 2018 revenue by the 2017 revenue and multiply by 100.
  3. Divide subsequent years' revenue by the 2017 revenue and multiply by 100.
• Graph trends in JB Hi-Fi Ltd’s sales revenue, EBIT and profit after tax for 2017 to 2021

Vertical Analysis

• Evaluates financial statement data by expressing each item as a percentage of a base amount (“common size statements”) to indicate relative magnitude.
• Common base:
  • Statement of profit or loss: % of Sales Revenue
  • Statement of financial position: % of Total Assets
• Useful for comparing companies of different sizes.
• Calculated percentages can be tracked over time to determine patterns of change.

Vertical Analysis (% of Sales Revenue)

• Gross Margin: The gross profit margin stands at 22%, indicating the percentage of revenue retained after covering the cost of goods sold.
• Operating Margin: Operating income (EBIT) represents 8% of total revenue, reflecting the efficiency of the company's core operations.
• Net Profit Margin: The net income margin is 6%, showing the portion of revenue that translates into profit after all expenses. 6 cents of every sale are converted to profit for owners.
• Expense Management: sales and marking expenses account for 9% of revenue, highlighting the company's spending on selling and advertising expenses. 9 cents for every sale.

Vertical Analysis (% of Total Assets)

• Asset Composition: Non-current assets constitute 55% of total assets, with property, plant, and equipment alone making up only 5%, indicating a small level of investment in long-term assets and inventory 29% - normal for retail.
• Liability Structure: Total liabilities represent 60% of total assets, with current liabilities accounting for 43%. Within current liabilities, accounts payable is 24% (high reliance on favorable credit terms), and deferred revenues are 3%. Not overly relying on debt - conservative.
• Equity Position: Shareholders' equity forms 40% of total assets, comprising contributed equity (12%), retained earnings (26%), and reserves (3%).

Ratio Analysis

• Examines the relationship between two quantitative amounts by expressing the relationship in ratio or percentage form.
• The ratio comparison can be between two different statements, but this is not always straightforward:
  • Statement of profit or loss and statement of cash flows is like a video: for the year ended…
  • Statement of financial position reports like a photo or snapshot at a moment in time: as at …

Ratio Analysis Categories

• Profitability ratios: measure of the profit relative to the resources available to generate the profit.
• Efficiency ratios: the sales generated per dollar invested in assets.
• Liquidity ratios: measure of the short-term ability of the entity to pay its maturing obligations and to meet unexpected needs for cash.
• Capital structure ratios: an entity’s ability to meet its long-term stability and financing decisions.
• Market performance ratios: relevant to companies listed on an organized stock exchange and generally relate the entity’s financial numbers to the entity’s share price and indicate the market’s sentiment towards the company.

Benchmarks

Ratios are of limited usefulness unless compared to relevant benchmarks.

• Identify trends in the entity’s ratios over time to assess the stability and/or directional changes.
• Intra-industry analysis: comparisons with other entities in the same industry.
  • Use ratios to compare respective returns and risks.
  • Assesses entity’s return and risk relative to its competitors, to determine if it is outperforming or lagging behind its peers.
• Inter-industry analysis: the entity’s ratios compared with those of entities operating in different industries; different industry structures will affect the ratios.
• Arbitrary standards: not possible to specify what a ratio should be rules of thumb that serve as a guide.

Focus for Ratio Analysis

• Calculations themselves are relatively mechanical, and spreadsheets and other tools can be used to assist this process.
• Note that we will not look at every ratio mentioned in the text.
• We will use the formulae provided in the prescribed text, and note that different formulae are often used.
• Note that some ratios use year-end figures to reflect a moment in time, & others use averages to reflect a more smoothed approach across the year.
• Interpreting and analyzing to answer the ‘why’ questions such as why did profitability decline or efficiency improve.

Profit & Loss Statement/ Income Statement

• Different levels of profit:
  • Profit (Net Profit after tax)
  • Add back: Income Tax Expense
  • NPBT (Net Profit before tax)
  • Add back: Interest (finance costs net of interest received)
  • EBIT (Earnings before interest and tax)
  • Add back: Depreciation and amortization
  • EBITDA (Earnings before interest, tax, depreciation, and amortization)

Profitability Analysis: Return on Equity (ROE)

• Captures profitability, efficiency, and capital structure.
• An upward trend is advantageous for the entity.
• A sustained high ROE attracts new competitors to the industry and may eventually erode excess ROE.
• $ROE = \frac{Profit available to owners}{Average equity} × 100$

Profitability Analysis: Return on Assets (ROA)

• Reflects the results of entity’s ability to convert sales revenue into profit, generate income from its asset investments
• $ROA = \frac{Profit or loss}{Average total assets} × 100$

Profitability Analysis: Profit Margin Ratios

Gross Profit Margin

• The mark-up on goods sold must cover all other operating expenses.
• Gross Profit = Sales – Cost of sales
• $Gross profit margin = \frac{Gross profit}{Sales revenue} × 100$

Profit Margin or Net Profit Margin

• How many cents of profit remain out of every dollar of sales after all expenses have been met
• High volume firms (e.g., supermarkets) generally experience low-profit margins.
• Low volume firms (e.g., luxury cars) have high-profit margins.
• $Profit margin = \frac{Profit or loss}{Sales Revenue} x 100$

Cash Flow to Sales Ratio

• Measures the relative amount of cash flow from operating activities compared to sales.
• It is useful to compare this to the profit margin, which is the accrual accounting-based ratio.
• $Cash flow to sales ratio = \frac{Cash flow from operating activities}{Sales revenue} × 100$

Asset Efficiency Analysis: Asset Turnover Ratio

• Shows an entity’s overall efficiency in generating income per dollar of investments in assets.
• Value will depend on the efficiency with which it manages its current and non-current investments.
• $Asset turnover ratio = \frac{Sales revenue}{Average total assets}$

Asset Efficiency Analysis: Days Inventory

• Days inventory ratio indicates the average period of time it takes to sell inventory.
• $Days inventory = \frac{Average inventory}{Cost of sales} × 365 days$

Asset Efficiency Analysis: Days Debtors

• Days debtors ratio indicates the average period of time it takes to collect the money from its trade-related accounts receivable.
• $Days debtors = \frac{Average trade debtors}{Sales revenue} × 365 days$

Asset Efficiency Analysis: Inventory Turnover

• It is common to calculate the number of times per annum that inventory are sold or turned over.
• $Inventory turnover = \frac{Cost of sales}{Average inventory}$

Asset Efficiency Analysis: Debtors Turnover

• The number of times per annum that trade debtors are turned over.
• $Debtors turnover = \frac{Sales revenue}{Average trade debtors}$

Days Inventory and Days Debtors Ratios

• Activity cycle: Days inventory and days debtors considered together reflect the average time it takes to convert inventory into cash (also referred to as the operating cycle).
• Cash cycle: The period of time between an entity paying for the inventory, selling the inventory, and receiving cash for the inventory.

Limitations of Ratio Analysis

• Ratio analysis is only one financial analysis tool.
• Comprehensive and effective financial analysis considers information beyond financial reported numbers.
• Non-financial considerations, such as ESG performance, are also taken into consideration by users when assessing an entity’s performance.
• Limitations of the analytical process need to be considered when interpreting and relying on the ratios to form an opinion as to a firm’s financial health, past, present, and future.
• Limitations relate to the nature of the financial statements and the data disclosed (or not disclosed), while others are inherent in the nature of the financial ratios themselves.
• For example, the information may be outdated, or comparability may be impeded by accounting policy and estimation choices.