Financial Analysis: The Big Picture

Characteristics of Financial Analysis

• Financial analysis evaluates a company's performance using:

  • Liquidity: Ability to meet short-term obligations.

  • Profitability: Ability to generate earnings relative to revenue, assets, and equity.

  • Solvency: Ability to meet long-term obligations.

Comparison Bases

• Financial statement analysis benchmarks a company's performance:

  • Intracompany: Comparing current performance to the company's past performance.

  • Industry Averages: Comparing performance against industry peers to identify best practices or areas needing improvement.

  • Intercompany: Comparing performance to direct competitors to assess competitive positioning.

Tools of Analysis

• Financial analysis employs several techniques:

  • Horizontal Analysis: Trend analysis over a period.

  • Vertical Analysis: Common-size analysis relative to a base amount.

  • Ratio Analysis: Expressing relationships between financial statement items.

Horizontal Analysis

• Also known as trend analysis, it evaluates financial statement data over time to determine increases or decreases.

• Commonly applied to:

  • Statement of financial position (balance sheet).

  • Income statement.

  • Retained earnings statement.

Quality Department Store - Statement of Financial Position Horizontal Analysis

• Assets Section:

  • Plant assets (net) increased by €167,500, or 26.5% ( $\frac{(800,000 - 632,500)}{632,500} = 26.5$ ).

• Equity Section:

  • Retained earnings increased by €202,600, or 38.6%.

• Liabilities Section:

  • Current liabilities increased by €41,500, or 13.7%.

• Overall: The company expanded its asset base, financed primarily by retained income rather than long-term debt.

Quality Department Store - Income Statement Horizontal Analysis

• Sales Revenue: Increased by €235,000, or 12.0%.

• Sales Returns and Allowances: Decreased by €25,000, or (20.3%).

• Net Sales: Increased by €260,000, or 14.2%.

• Cost of Goods Sold: Increased by €141,000, or 12.4%.

• Gross Profit: Increased by €119,000, or 17.1%.

• Selling Expenses: Increased by €41,500, or 19.6%.

• Administrative Expenses: Decreased by €4,500, or (4.1%).

• Total Operating Expenses: Increased by €37,000, or 11.6%.

• Income from Operations: Increased by €82,000, or 21.8%.

• Interest and Dividends: Decreased by €2,000, or (18.2%).

• Interest Expense: Decreased by €4,500, or (11.1%).

• Income Before Income Taxes: Increased by €84,500, or 24.3%.

• Income Tax Expense: Increased by €29,200, or 21.0%.

• Net Income: Increased by €55,300, or 26.5%.

• Overall: Favorable profit trend due to substantial increases in gross profit and net income.

Quality Department Store - Retained Earnings Statement Horizontal Analysis

• Retained Earnings, Jan. 1: Increased by €148,500, or 39.4%.

• Net Income: Increased by €55,300, or 26.5%.

• Dividends: Increased by €1,200, or 2.0%.

• Retained Earnings, Dec. 31: Increased by €202,600, or 38.6%.

• Overall: A significant portion of net income was retained to finance additional plant facilities.

Vertical Analysis

• Also called common-size analysis, it expresses each financial statement item as a percentage of a base amount.

• Income Statement: Selling expenses as a percentage of net sales.

• Statement of Financial Position: Current assets as a percentage of total assets.

• Commonly applied to the statement of financial position and the income statement to facilitate comparative analysis.

Quality Department Store - Statement of Financial Position Vertical Analysis

• Assets Section: Current assets decreased from 59.2% to 55.6% of total assets; plant assets (net) increased from 39.7% to 43.6% of total assets.

• Equity and Liabilities: Retained earnings increased from 32.9% to 39.7% of total equity and liabilities.

• Overall: The company finances growth through earnings retention rather than increased debt.

Quality Department Store - Income Statement Vertical Analysis

• COGS: Declined 1% as a percentage of net sales.

• Total Operating Expenses: Declined 0.4%.

• Net Income: Increased from 11.4% to 12.6% as a percentage of net sales.

• Overall: Quality Department Store is a profitable and increasingly successful business.

Comparative Income Statement Vertical Analysis

• Enables comparison of companies of different sizes by highlighting differences in expense management and profitability.

• Compares net income as a percentage of each sales euro and identifies differences in gross profit rates due to selling and administrative expenses.

Ratio Analysis

• Expresses relationships among selected financial statement data to evaluate:

  • Liquidity Ratios: Measure short-term ability to pay obligations.

  • Profitability Ratios: Measure income and operating success.

  • Solvency Ratios: Measure long-term survival ability.

1. Liquidity Ratios

• Measure the short-term ability to pay maturing obligations and meet unexpected cash needs.

• Short-term creditors use these to assess liquidity.

• Ratios include:

  • Current Ratio

  • Acid-Test Ratio

  • Accounts Receivable Turnover

  • Inventory Turnover

1.1 Current Ratio

• Formula: $Current Ratio = \frac{Current Assets}{Current Liabilities}$

• Quality Department Store:

  • 2020: $\frac{€1,020,000}{€344,500} = 2.96:1$

  • 2019: $\frac{€945,000}{€303,000} = 3.12:1$

• Interpretation: Quality has €2.96 of current assets for every euro of current liabilities in 2020.

1.2 Acid-Test Ratio

• Formula: $Acid-Test Ratio = \frac{Cash + Short-Term Investments + Receivables (net)}{Current Liabilities}$

• Quality Department Store:

  • 2020: $\frac{€100,000 + €20,000 + €230,000}{€344,500} = 1.02:1$

  • 2019: $\frac{€155,000 + €70,000 + €180,000}{€303,000} = 1.34:1$

• The acid-test ratio measures immediate liquidity, indicating the ability to cover current liabilities with the most liquid assets.

1.3 Accounts Receivable Turnover

• Formula: $Accounts Receivable Turnover = \frac{Net Credit Sales}{Average Net Accounts Receivable}$

• Measures how many times a company collects receivables during a period.

• Quality Department Store:

  • 2020: $\frac{€2,097,000}{\frac{€180,000 + €230,000}{2}} = 10.2 \text{ times}$

• Average Collection Period: $\frac{365 \text{ days}}{10.2 \text{ times}} = 35.78 \text{ days}$

• Interpretation: Receivables are collected, on average, every 36 days, reflecting the efficiency of credit and collection policies.

1.4 Inventory Turnover

• Formula: $Inventory Turnover = \frac{Cost of Goods Sold}{Average Inventory}$

• Measures the number of times inventory is sold during the period.

• Quality Department Store:

  • 2020: $\frac{€1,281,000}{\frac{€500,000 + €620,000}{2}} = 2.3 \text{ times}$

• Days in Inventory: $\frac{365 \text{ days}}{2.3 \text{ times}} = 159 \text{ days}$

• Inventory turnover ratios vary considerably among industries, influenced by factors like product type and demand.

2. Profitability Ratios

• Measure the income or operating success of a company over a period of time.

• Income affects the ability to obtain financing, liquidity, and growth.

• Ratios include:

  • Profit Margin

  • Asset Turnover

  • Return on Assets

  • Return on Ordinary Shareholders’ Equity

  • Earnings Per Share

  • Price-Earnings Ratio

  • Payout Ratio

2.1 Profit Margin

• Formula: $Profit Margin = \frac{Net Income}{Net Sales}$

• Measures the percentage of each sales dollar that results in net income.

• Quality Department Store:

  • 2020: $\frac{€263,800}{€2,097,000} = 12.6$

  • 2019: $\frac{€208,500}{€1,837,000} = 11.4$

2.2 Asset Turnover

• Formula: $Asset Turnover = \frac{Net Sales}{Average Assets}$

• Measures how efficiently a company uses its assets to generate sales; higher turnover indicates greater efficiency.

• Quality Department Store:

  • 2020: $\frac{€2,097,000}{\frac{€1,595,000 + €1,835,000}{2}} = 1.2 \text{ times}$

2.3 Return on Assets

• Formula: $Return on Assets = \frac{Net Income}{Average Assets}$

• An overall measure of profitability, indicating how well a company uses its assets to create profit.

• Quality Department Store:

  • 2020: $\frac{€263,800}{\frac{€1,595,000 + €1,835,000}{2}} = 15.4$

  • 2019: $\frac{€208,500}{\frac{€1,446,000 + €1,595,000}{2}} = 13.7$

2.4 Return on Ordinary Shareholders’ Equity

• Formula: $Return on Ordinary Shareholders’ Equity = \frac{Net Income - Preference Dividends}{Average Ordinary Shareholders’ Equity}$

• Shows how many euros of net income the company earned for each euro invested by the owners; reflects profitability from the shareholders' perspective.

• Quality Department Store:

  • 2020: $\frac{€263,800 - €0}{\frac{€795,000 + €1,003,000}{2}} = 29.3$

  • 2019: $\frac{€208,500 - €0}{\frac{€667,000 + €795,000}{2}} = 28.5$

2.5 Earnings per Share (EPS)

• Formula: $Earnings per Share = \frac{Net Income - Preference Dividends}{Weighted-Average Ordinary Shares Outstanding}$

• A measure of the net income earned on each ordinary share, indicating a company's profitability on a per-share basis.

• Quality Department Store:

  • 2020: $\frac{€263,800 - €0}{275,400} = €0.97$

  • 2019: $\frac{€208,500 - €0}{270,000} = €0.77$

2.6 Price-Earnings Ratio

• Formula: $Price-Earnings Ratio = \frac{Market Price per Share}{Earnings per Share}$

• Reflects investors’ assessments of a company’s future earnings; higher P/E ratios may indicate expectations of higher future growth.

• Quality Department Store:

  • 2020: $\frac{€12.00}{€0.97} = 12.4 \text{ times}$

  • 2019: $\frac{€8.00}{€0.77} = 10.4 \text{ times}$

2.7 Payout Ratio

• Formula: $Payout Ratio = \frac{Cash Dividends Declared on Ordinary Shares}{Net Income}$

• Measures the percentage of earnings distributed as cash dividends, indicating what portion of profit is returned to shareholders.

• Quality Department Store:

  • 2020: $\frac{€61,200}{€263,800} = 23.2$

  • 2019: $\frac{€60,000}{€208,500} = 28.8$

3. Solvency Ratios

• Measure the ability of a company to survive over a long period of time, assessing its financial stability and risk.

• Debt to Total Assets and Times Interest Earned are two ratios that provide information about debt-paying ability, crucial for long-term sustainability.

3.1 Debt to Assets Ratio

• Formula: $Debt to Assets Ratio = \frac{Total Liabilities}{Total Assets}$

• Measures the percentage of the total assets that creditors provide, indicating the extent of a company’s leverage.

• Quality Department Store:

  • 2020: $\frac{€832,000}{€1,835,000} = 45.3$

  • 2019: $\frac{€800,000}{€1,595,000} = 50.2$

3.2 Times Interest Earned (Interest Coverage)

• Formula: $Times Interest Earned = \frac{Net Income + Interest Expense + Income Tax Expense}{Interest Expense}$

• Indicates a company’s ability to meet interest payments as they come due, reflecting its capacity to handle debt obligations.

• Quality Department Store:

  • 2020: $\frac{€263,800 + €36,000 + €168,200}{€36,000} = 13 \text{ times}$

  • 2019: $\frac{€208,500 + €40,500 + €139,000}{€40,500} = 9.6 \text{ times}$

Summary of Ratios

Liquidity Ratios

• Current Ratio: $\frac{\text{Current assets}}{\text{Current liabilities}}$. Measures short-term debt-paying ability, indicating if a company has enough short-term assets to cover its short-term liabilities.

• Acid-Test (Quick) Ratio: $\frac{\text{Cash + Short-term investments + Accounts receivable (net)}}{\text{Current liabilities}}$. Measures immediate short-term liquidity, showing the ability to cover current liabilities with the most liquid assets.

• Accounts Receivable Turnover: $\frac{\text{Net credit sales}}{\text{Average net accounts receivable}}$. Measures liquidity of accounts receivable, indicating how efficiently a company collects its receivables.

• Inventory Turnover: $\frac{\text{Cost of goods sold}}{\text{Average inventory}}$. Measures liquidity of inventory, showing how quickly inventory is sold and replenished.

Profitability Ratios

• Profit Margin: $\frac{\text{Net income}}{\text{Net sales}}$. Measures net income generated by each currency unit of sales, reflecting overall profitability.

• Asset Turnover: $\frac{\text{Net sales}}{\text{Average total assets}}$. Measures how efficiently assets are used to generate sales, indicating asset utilization efficiency.

• Return on Assets: $\frac{\text{Net income}}{\text{Average total assets}}$. Measures overall profitability of assets, showing how well assets are used to generate profit.

• Return on Ordinary Shareholders' Equity: $\frac{\text{Net income - Preference dividends}}{\text{Average ordinary shareholders' equity}}$. Measures profitability of owners' investment, reflecting how much profit is earned for each euro invested by shareholders.

• Earnings Per Share (EPS): $\frac{\text{Net income - Preference dividends}}{\text{Weighted-average ordinary shares outstanding}}$. Measures net income earned on each ordinary share, indicating a company's profitability on a per-share basis.

• Price-Earnings (P-E) Ratio: $\frac{\text{Market price per share}}{\text{Earnings per share}}$. Measures the ratio of the market price per share to earnings per share, reflecting investors’ expectations of future earnings.

• Payout Ratio: $\frac{\text{Cash dividends declared on ordinary shares}}{\text{Net income}}$. Measures percentage of earnings distributed in the form of cash dividends, indicating the portion of profit returned to shareholders.

Solvency Ratios

• Debt to Assets Ratio: $\frac{\text{Total liabilities}}{\text{Total assets}}$. Measures the percentage of total assets provided by creditors, indicating the extent of a company