FINM02-6

Topic 2: Financial Statement Analysis

 Introduction
• This topic will cover the following:
̶ Objectives of financial reporting

̶ Users of financial statements and their information needs

̶ Key financial statements

̶ Approaches to financial statement analysis

̶ Calculation and interpretation of financial ratios

 Objectives of Financial Reporting

• Financial statements are a key source of information about a firm

• Companies are required to prepare and present financial statements
according to IFRS
• According to IFRS, the objective of financial reporting is to:
– Provide financial information (on economic resources, claims on these resources,
and changes in both resources and claims) about the reporting entity
– That is useful (should possess fundamental and enhancing characteristics) to existing
and potential investors, lenders and other creditors
– In making decisions about providing resources to the entity
 Users of Financial Reports

• IFRS identifies external providers of capital as the primary users of financial

reports. These capital providers include:
– Existing and potential investors
– Lenders and other creditors
• Other users if financial reports include:
̶ Management
̶ Employees
̶ Acquisition and merger analysts
̶ Auditors
̶ Other interested parties (SARS, customers, competitors, public)
 Qualitative Characteristics of Financial
Reporting

• For information to be useful, it needs to possess certain fundamental and

enhancing characteristics
• Fundamental qualitative characteristics include:
– Relevance
• Should have predictive and confirmatory value
– Faithful representation
• Information should be complete, neutral and free from error
 Qualitative Characteristics of
Financial Reporting

• Enhancing qualitative characteristics include:

– Comparability
• Enables users to identify similarities and differences among items over time and across
different entities
– Verifiability
• Enables knowledgeable and independent observers to reach a consensus that an event
or transaction is fairly represented
– Timeliness
• Broadly concerned with the ability to influence decision makers
– Understandability
• Users are able to comprehend its meaning
 Annual Financial Statements
• According to IFRS, a complete set of financial statements comprises of:
̶ Statement of Financial Position;
̶ Statement of Comprehensive Income;
̶ Statement of Changes in Equity;
̶ Statement of Cash Flows; and
̶ Notes
 Annual Financial Statements cont.
• Statement of Financial Position:
̶ Provides a summary of an entity’s financial position at a specified date
̶ It is divided into two sections showing the:
• Investment decision:
̶ Non-current assets (PPE and financial assets)
̶ Current assets
• Financing decision:
̶ Equity
̶ Debt (Non-current and current liabilities)
 Annual Financial Statements cont.
• Statement of Comprehensive Income:
̶ Provides a summary of an entity’s financial performance over a specified
period of time, usually a year
̶ It provides information related to an entity’s operations
̶ The information is divided into two main categories:
• Income:
̶ Sales (also referred to as revenue or turnover)
̶ Other income (e.g. rental income and commission income)
• Expenses:
̶ Operating expenses (salaries, advertising, depreciation e.t.c)
̶ Finance costs (interest expense) and taxation
 Annual Financial Statements cont.
• Statement of Cash Flows:
̶ Provides a summary of an entity’s ability to generate cash over a specified
period of time, usually a year
̶ It provides information on transactions involving cash only
̶ The information is divided into three main categories:
• Cash flows from operating activities
– Cash from customers and payments to employees and suppliers
• Cash flows from investing activities
– Disposal and acquisition of non-current assets and investments
• Cash flows from financing activities
– Issue and repayment of debt and equity
 Limitations of Accounting Data

• Only reflects variables that can be expressed in money terms

• Suffers from simplification and summarisation
• Different accounting policies can be used
• Based on historical figures and does not reflect inflation adequately
 Approaches to FS Analysis
• Common techniques include:
̶ Comparative financial statements and trend analysis;
̶ Index analysis;
̶ Common size analysis; and
̶ Ratio analysis.
 Ratio Analysis
• Ratios provide a useful way of comparing the financial performance and
position of a business over time and against competitors
• However, to be useful the ratios need to be:
̶ Meaningful
• The relationship being investigated must be logical
̶ A true reflection of the financial performance of the company
• Only relevant amounts must be used to measure the variable of interest
̶ Comparable
• Over time and between companies and industries
 Ratio Analysis cont.
• Ratios may be categorised into six groups:
̶ Liquidity ratios
̶ Asset management ratios (turnover and turnover time ratios);
̶ Solvency ratios;
̶ Profitability ratios (profitability and profit margins);
̶ Cash flow ratios; and
̶ Investment ratios.
 Liquidity Ratios
• Measure a company’s ability to meet its maturing obligations
• Focus on current assets and current liabilities
• Two main measures of liquidity are:
Current assets
• Current ratio = Current liabilities
̶ Measures ability to meet maturing obligations using short-term assets
̶ Ideal ratio should be in the region of 2:1
(Current assets − inventory)
• Quick (Acid-test) ratio = Current liabilities
̶ Stricter than the current ratio
̶ Excludes inventory since it is the least liquid current asset
̶ Ideal ratio should be in the region of 1:1
 Liquidity Ratios cont.
• An additional measures of liquidity is the cash ratio
• It focuses only on the cash and cash equivalents portion of current assets
• It is calculated as follows:
Cash
• Cash ratio = Current liabilities

̶ Measures ability to meet maturing obligations using cash and cash equivalents
̶ Cash is the most liquid, but also least productive current asset
̶ Most businesses do not keep sufficient cash to cover current liabilities
̶ Ideal ratio should be in the region of 0.20:1
 Asset Management Ratios
• Measure how effectively management is using the company’s assets
• Popular ratios include:
Sales
• PPE turnover = Average PPE at carrying value

̶ Measures how efficient management is in using fixed assets to generate sales

̶ Shows the value of sales generated by each rand spent on fixed assets
̶ The higher the ratio, the more efficient management is at using fixed assets
Sales
• Asset turnover = Operating assets
̶ Similar to the fixed asset turnover, but uses total assets
Asset Management Ratios cont.
Cost of sales
• Inventory turnover = Average inventory

̶ Measures the number of times inventory is sold during the year

̶ The higher the inventory turnover, the more efficient the entity is in selling inventory
Average accounts receivable
• Trade receivables turnover time = Sales
x 365 (or 360) days

̶ Also known as the average collection period, measures the length of time it takes to
collect money from credit customers
̶ The shorter the collection period the better
̶ However care should be taken not to chase customers away
Asset Management Ratios cont.
Average inventory
• Inventory turnover time = Cost of sales
x 365 (or 360) days

̶ Measures the length of time it takes to sell inventory

̶ The shorter the period the better since some inventory is seasonal or becomes
obsolete
Average accounts payable
• Trade payables turnover time = Purchases
x 365 (or 360) days

̶ Also known as the average payment period, measures the length of time it takes to pay
suppliers
̶ The longer the collection period the better
̶ However care should be taken not to go beyond the agreed credit terms and tarnish
the company’s reputation
 Solvency Ratios
• Measure the extent to which a company relies on debt funding
• Provide an indication of a company’s chances of long-term survival
• Popular ratios include:
Total debt
• Debt to assets ratio = Total assets x 100

̶ Shows the proportion of assets financed by debt

̶ The higher the ratio, the heavier the company’s reliance on debt
Total debt
• Debt to equity ratio = x 100
Total equity
̶ Indicates the extent that debt is covered by shareholders’ funds
̶ The lower the ratio, the lower the financial risk faced by the company
 Solvency Ratios cont.
Average total assets
• Financial leverage ratio = Average total equity

– Also known as the equity multiplier, shows the extent to which the company’s assets
were financed by equity
– A ratio above 1 shows that some of the assets were financed by debt
– The higher the ratio (above 1), the more debt was used to finance assets
EBIT
• Finance cost coverage = Finance cost

̶ Shows the extent that interest is covered by operating income

̶ Finance cost often refers to the cost of borrowed funds (interest)
̶ A higher ratio suggests that the company will comfortably service its debt
 Profitability Ratios
• Show a company's overall efficiency and performance
• Measure how effectively management is generating profits
• Popular ratios include:
Gross profit
• Gross profit margin = Sales
x 100

̶ Shows the proportion of sales left after covering cost of sales

̶ A higher ratio can be arrived at by increasing selling prices and lowering the cost of sales
EBIT
• Operating profit margin = x 100
Sales
̶ Shows the proportion of sales left after covering cost of sales and operating expenses
̶ Reducing operating costs can help increase the ratio
 Profitability Ratios cont.
Net profit
• Net profit margin = Sales x 100
̶ Shows the proportion of sales that can be attributed to the owners of the company after
all expenses have been met
Net profit
• Return on assets = x 100
Total assets
̶ Measures the profitability of the firm as a whole in relation to the total assets employed
Net profit
• Return on equity = x 100
Total shareholders′ equity
̶ Measures management’s ability to generate profit for shareholders
̶ If a company is offering a lower return on equity, shareholders might sell their shares
and invest in more profitable businesses
 Cash Flow Ratios
• Cash flow is regarded as the life blood of any business
• Most important ratio is:
Cash flow from operations
• Cash flow to turnover = Sales
̶ Reflects a company’s ability to convert sales into cash flow
̶ A higher ratio is preferred as it suggests that more cash is being received from sales

Cash flow from operations

• Debt repayment coverage = Repayments of long−term debt

̶ Reflects a company’s ability to meet its maturing debt obligations from cash generated
from operations
̶ A higher ratio suggests that the company will not likely suffer financial distress
 Investment Ratios
• Of particular interest to investors
• Combine stock market and financial statement data
• Popular ratios include:
Profit after tax, non−controlling interest and pref. dividends
• Earnings per share (EPS) = Number of ordinary shares issued
̶ Indicates the profit attributable to each ordinary share issued
̶ A higher ratio is desirable, but other factors need to be considered
Price per share
• Price-earnings (P/E) ratio = Earnings per share
̶ Indicates how much investors are willing to pay per rand of reported profits
̶ Generally PE ratios are higher for firms with high growth prospects and lower for firms
regarded as risky
 Investment Ratios cont.
Total ordinary dividends
• Dividend per share (DPS) ratio = Number of ordinary shares issued
̶ Indicates how much investors received in dividends per each share held
̶ Some shareholders prefer higher DPS, while others prefer a lower DPS

Earnings per share

• Dividend coverage ratio =
Dividend per share
̶ Measures the extent of earnings that are being paid out in the form of dividends
̶ A high ratio would indicate that a large percentage of earnings are being retained within
the business
 Investment Ratios cont.
Dividend per share
• Dividend payout ratio = Earnings per share
̶ Indicates the proportion of the company’s earnings paid out as dividends to shareholders
̶ It is advisable that companies payout any earnings in excess of investment needs
̶ If the business does not have viable opportunities, shareholders are better off receiving
dividends
Price per share
• Market-to-book (MTB) value ratio =
Book value per share
̶ Measures the extent to which management have created value for shareholders
̶ The book value is a historical measure, while the market value represents the future
earning potential of assets
̶ Where the ratio is above 1, management have created value for shareholders
 Du Pont Analysis
• Of primary importance to shareholders is the ROE
• The ROE is often a reflection of management performance and is affected
by three main factors:
– Profitability (as measured by the net profit margin);
– Efficiency in managing assets (as measured by the total asset turnover); and
– Solvency (as measured by the financial leverage ratio)
• Putting it all together, the ROE can be broken into:
• ROE = Net profit margin x Total asset turnover x Financial leverage ratio

• Using the Du Pont analysis, it becomes easy to identify the main cause of a
change in the ROE
 End of Topic 2

• Questions ???
• Answer self-assessment questions at the end of Chapter 3.