Comprehensive Guide to Financial Statement Analysis and Ratio Decomposition and Ratios

Introduction to Financial Management

• Financial management is a critical internal process necessary for ensures that an organization (profit or nonprofit) remains fiscally responsible. The understanding of financial management practices and the construction of basic systems are the foundation for a healthy and sustainable organization.

• Financial management encompasses several key aspects:

  • Financial statement analyses: Includes the review of income statements, balance sheets, and cash flow statements.

  • Capital budgeting: Techniques and methods used to compare investment alternatives, typically involving the analysis of future positive and negative cash flows.

  • Taxation.

  • Legal considerations: Public activities such as lobbying, advocacy, contracts, risk management, and public support.

  • Accounting: Bookkeeping systems that follow specific standards to develop and report financial transactions.

  • Sustainability: The capacity of a firm to develop strategies for long-term growth and development.

• Standard techniques for analyzing financial statements include ratio analysis, horizontal analysis, and vertical analysis, which allow for comparison across different reporting periods.

The Balance Sheet

• The balance sheet shows the financial condition of a company at a particular point in time or on a specific date.

• It is structured around the fundamental accounting equation:

  • $\text{Assets} = \text{Liabilities} + \text{Stockholders' Equity}$

• Assets: Future economic benefits obtained or controlled by an entity resulting from past transactions. These can be physical (land, buildings, equipment) or intangible (patents, trademarks).

  • Current Assets: Cash or assets capable of being converted into cash within one year. They relate to company liquidity. Examples include cash, marketable securities (government bonds, common stock, certificates of deposit), short-term receivables, inventories, and pre-paids (taxes, insurance).

  • Long-term Assets: Assets that require more than one year or one operating cycle to convert to cash. These include tangible assets, investments, and intangible assets.

  • Depreciation: The process of allocating the cost of buildings and machinery over time. The straight-line method formula is:

    • $\text{Annual depreciation} = \frac{\text{cost} - \text{salvage value}}{\text{estimated life}}$

• Liabilities: Future sacrifices arising from present obligations to transfer assets or provide services.

  • Current Liabilities: Obligations requiring liquidation of existing assets within one year (e.g., payables, unearned income).

  • Long-term Liabilities: Obligations due later than one year, including financing arrangements (notes payable, bonds payable, credit arrangements) and operational obligations (pension obligations, deferred taxes, service warranties).

  • Deferred Taxes: Result from differences in accounting methods for tax versus reporting systems, such as using accelerated depreciation for taxes and straight-line for reporting.

• Stockholders' Equity: The residual ownership interest in assets after deducting liabilities. It is divided into:

  • Paid-in capital: Preferred or common stock.

  • Retained earnings: Undistributed earnings (net income of past periods minus declared dividends).

The Income Statement

• The income statement summarizes revenues, expenses, gains, and losses, ending with the net income for a specific period.

• Multiple-step format: Separately presents gross profit, operating income, income before taxes, and net income.

• Single-step format: Groups all revenues and gains together, then deducts all expenses and losses.

• Key Components:

  • Net sales (sales turnover): Revenue from goods/services, net of discounts, returns, or allowances.

  • Cost of Goods Sold (COGS): The costs to produce revenue.

    • Retail COGS formula: $\text{COGS} = \text{Beginning Inventory} + \text{Purchases} - \text{Ending Inventory}$

    • Manufacturing COGS: Includes raw materials, labor, and overhead. It involves tracking Raw Materials, Work in Process (WIP), and Finished Goods.

  • Non-operating income: Income from secondary activities (dividend income, rental income).

  • Special items: Unusual or nonrecurring items like natural disaster losses or inventory write-downs.

  • Earnings per share (EPS): Basic earnings per share before extraordinary items and discontinued operations.

The Cash Flow Statement

• The cash flow statement examines all balance sheet accounts to explain changes in cash and short-term liquid investments. It helps determine dividend policy, cash generated by operations, and investing/financing policies.

• Classification of Activities:

  • Operating Activities: Usually involve income statement items (cash inflows from income/returns on loans; outflows for inventory, salaries, taxes, interest).

  • Investing Activities: Involve long-term asset items (cash inflows from loan collections, sale of securities or property; outflows for purchasing machinery or securities).

  • Financing Activities: Involve long-term liability and equity items (cash inflows from issuing stock/bonds; outflows for dividends, reacquiring stock, or repaying debt).

• Presentation Methods:

  • Direct Method: Presents the income statement on a cash basis.

  • Indirect Method: Adjusts net income for items that affected income but not cash (e.g., adding back depreciation, adjusting for inventory increases/decreases).

Basics of Financial Statement Analysis

• Common techniques include ratio analysis, common size analysis, cross-company comparisons, trend analysis, and year-to-year analysis.

• It is critical to compare companies against benchmarks within their own specific industry, as ratios vary significantly across sectors.

• Roles of Ratios:

  • Structural analysis: Clarifies the relationship between items on financial reports.

  • Time-series analysis: Matches a borrower's performance against historical levels.

  • Cross-sectional analysis: Compares performance with industry averages.

Liquidity Ratios

• Liquidity ratios measure a firm's ability to meet current obligations. Failure to meet short-term obligations can lead to bankruptcy even for profitable firms.

• Days' Sales in Receivables: Measures collection efficiency. Results should be equal to or less than the firm's credit terms.

  • $\text{Days' sales in receivables} = \frac{\text{gross receivables}}{\frac{\text{net sales}}{365}}$

  • Case Study (Haverty Furniture): 2009: $104.2\,\text{days}$; 2010: $104.0\,\text{days}$; 2011: $104.4\,\text{days}$.

• Accounts Receivable Turnover in Days: Indicates liquidity of receivables; should be as small as possible.

  • $\text{AR turnover in days} = \frac{\text{average gross receivables}}{\frac{\text{net sales}}{365}}$

• Days' Sales in Inventory: The time required to use up inventory through sales.

  • $\text{Days' sales in inventory} = \frac{\text{ending inventory}}{\frac{\text{COGS}}{365}}$

  • Case Study (Haverty Furniture): 2009: $129.3\,\text{days}$; 2010: $117.9\,\text{days}$; 2011: $121.3\,\text{days}$.

• Operating Cycle: Measures the time between the acquisition of goods and the collection of cash from sales.

  • $\text{Operating cycle} = \text{Inventory turnover in days} + \text{Receivable turnover in days}$

• Working Capital: Indicates short-run solvency.

  • $\text{Working capital} = \text{Current Assets} - \text{Current Liabilities}$

• Current Ratio: Standard measure of short-term paying ability. A ratio of $2.0$ is generally considered good, though many modern companies operate below this.

  • $\text{Current ratio} = \frac{\text{current assets}}{\text{current liabilities}}$

• Acid-test (Quick) Ratio: A more stringent measure that removes inventory from current assets due to risks of obsolescence.

  • $\text{Acid-test ratio} = \frac{\text{current assets} - \text{inventory}}{\text{current liabilities}}$

Debt Ratios

• Debt ratios measure the protection for suppliers of long-term funds and the proportion of funds provided by outsiders.

• Debt Ratio: Indicates long-term debt-paying ability.

  • $\text{Debt ratio} = \frac{\text{total liabilities}}{\text{total assets}}$

  • Case Study (Haverty Furniture): Debt ratio constant at $0.32$ ($32\%$ of assets financed by creditors).

• Debt/Equity Ratio: Lower ratios indicate better debt positions.

  • $\text{Debt/equity ratio} = \frac{\text{total liabilities}}{\text{shareholder's equity}}$

• Debt to Tangible Net Worth Ratio: A conservative measure that removes intangible assets (goodwill, patents) from equity.

  • $\text{Debt to tangible net worth} = \frac{\text{total liabilities}}{\text{shareholder's equity} - \text{intangible assets}}$

Profitability Ratios

• These measure the earning ability of a firm and are critical for stockholders (dividends) and creditors (debt coverage).

• Net Profit Margin: Calculates return on sales.

  • $\text{Net profit margin} = \frac{\text{net income before extraordinary items}}{\text{net sales}}$

  • Case Study (Haverty Furniture): 2009: $-0.7\%$; 2010: $1.4\%$; 2011: $2.5\%$.

• Total Asset Turnover: Measures how much money is made for every dollar invested in assets.

  • $\text{Total asset turnover} = \frac{\text{net sales}}{\text{total assets}}$

  • Case Study (Haverty Furniture): 2009: $1.63$; 2010: $1.68$; 2011: $1.61$. A value of $1.63$ means $63\,\text{cents}$ generated for every dollar invested.

• Return on Assets (ROA): Measures efficiency in using assets to generate profit.

  • $\text{ROA} = \frac{\text{net income before extraordinary items}}{\text{total assets}}$

• Return on Investment (ROI): Evaluates performance regarding rewarding long-term fund providers.

  • $\text{ROI} = \frac{\text{net income before extraordinary items} + \text{interest expense} \times (1 - \text{tax rate})}{\text{long-term liabilities} + \text{equity}}$

• Return on Total Equity (ROE): Measures return to common and preferred stockholders.

  • $\text{ROE} = \frac{\text{net income before extraordinary items}}{\text{total equity}}$

Case Study: Trudy Patterns, Inc.

• Context: Trudy Patterns, Inc. is a costume jewelry manufacturer facing a deteriorating financial position. Loan terms required a minimum current ratio of $2.0$, which the firm fell below in 2010.

• Financial Trends (2008–2010):

  • Current Ratio: 2008: $3.05$; 2009: $2.67$; 2010: $1.75$ (Industry Average: $2.50$).

  • Quick Ratio: 2008: $1.65$; 2009: $1.08$; 2010: $0.73$ (Industry Average: $1.00$).

  • Average Collection Period (ACP): 2008: $37\,\text{days}$; 2009: $37\,\text{days}$; 2010: $55\,\text{days}$ (Industry Average: $32\,\text{days}$).

  • Inventory Turnover (Cost): 2008: $7.1X$; 2009: $4.5X$; 2010: $3.6X$ (Industry Average: $5.7X$).

  • Net Profit Margin: 2008: $5.5\%$; 2009: $3.4\%$; 2010: $0.39\%$ (Industry Average: $2.90\%$).

  • Debt Ratio: 2008: $40.6\%$; 2009: $46.5\%$; 2010: $59.87\%$ (Industry Average: $50.0\%$).

• Analysis: The company has too much inventory on hand, and its liquidity is worse than the current ratio suggests, likely due to obsolete inventory. The rising ACP suggests collection issues. Profitability is deteriorating due to higher raw material costs and increased wages despite aggressive marketing.

Limitations of Financial Ratios

• Accounting Flexibility: Different methods allowed under GAAP/IFRS can distort intercompany comparisons:

  • Inventory Valuation: LIFO (Last-in, First-out) vs. FIFO (First-in, First-out). LIFO often lowers income taxes during inflation.

  • Revenue Recognition: Contractors may use percentage-of-completion, affecting profit timing.

  • Depreciation: Accelerated methods minimize taxes but reduce reported income.

  • Capitalization of Costs: Software companies may capitalize development costs, affecting perceived cash flow.

• Structural Influences:

  • M&A Activity: Mergers and acquisitions can distort time-series analysis.

  • Geographic Differences: Local economies and demographics affect firms in the same industry (e.g., East Coast vs. West Coast transport companies).

  • Seasonality: Ratios can be distorted if measured against interim ratios during peak or off-peak seasons.

  • Size Differences: Large firms may benefit from economies of scale (e.g., Sony vs. small TV producers), making comparisons difficult.

• Window-dressing: Some firms manipulate financial statements just before issuing reports (e.g., selling a corporate aircraft for cash to boost liquidity).

Questions & Discussion

• Question (Exercise 1): In a manufacturing company, what does the Cost of Goods Sold (COGS) refer to?

  • Response: Raw material, direct labor, and overhead.

• Question (Exercise 6): If the operating cash flow is less than the net profit, what does it mean?

  • Response: The company is not able to turn its sales into cash.

• Discussion on Benchmarks: Industry averages should ideally be replaced by specific peer group benchmarks. If using averages, bankers should confirm that ratios fall within one standard deviation of the median.

• Dialogue on Loan Covenants: In the case of Trudy Patterns, Inc., the banker does not intend to force bankruptcy immediately but uses the loan agreement to encourage management to take decisive action to improve financial health.