Chapter 5

• year-to-year comparisons and trend analysis are useful in understanding an organization's performance.
• common-size financial statements translate pero amounts to percentage, which indicate the relative size of an item in proportion to the whole.
• purpose of common-size

  1. comprehend or visualize the changes
  2. compare the two or more companies statement
  3. point out the efficiencies and inefficiencies
• Guideline in the Interpretation of Common-size Statements

  • Statement of Financial Position - show assets, liabilities and equity
  • Income Statement - percentage of sales
• Financial Ratio Analysis is a comparison in fraction, proportion, decimal or percentage of two significant figures.

  Purpose - provide insight into the profitability of operations

  Limitation

  • used only as financial tools
  • computed without adjustment
  • many different figures
  • certain yardsticks
• Financial Ratio Analysis

  • Liquidity ratios - meets cash needs
  • Activity ratios - measures the liquidity of specific assets
  • Leverage ratios - debt to relative to equity
  • Profitability ratios - overall performance
• I. Analysis of Liquidity or Short-Term Solvency

  Current Ratio

  • current assets / current liabilities
  • measure of short term debt paying liabilities

  Quick or Acid test ratio

  • (Cash + marketable sec.+ AR, net) / current liabilities
  • rigorous test to meet its short term debts

  Cash-Flow Liquidity Ratio

  • (Cash + marketable sec. + cash flow form operating) / current liabilities
  • considers cash from operating activities
• Account Receivable Turnover:

  • Formula: Net Sales / Average of Accounts Receivable
  • Measures how many times the accounts receivable turn over
• Average Collection Period:

  • Formula: 365 days / Accounts Receivable Turnover or Average Accounts Receivable / Average daily sales
  • Evaluates the liquidity of accounts receivable and the firm's credit policies
• Inventory Turnover:

  • Formula: Cost of Goods Sold / Average Inventory balance
  • Measures the efficiency of managing and selling inventory
• Average Sale Period:

  • Formula: 365 days / Inventory turnover
  • Also known as the conversion period
• Fixed Asset Turnover:

  • Formula: Net Sales / Average Net Property, Plant, and Equipment
  • Indicates the ability to generate sales from the investment in fixed assets
• Total Asset Turnover:

  • Formula: Net Sales / Average Total Assets
  • Evaluates the efficiency of management to generate sales
• Debt Ratio

  • Total Liabilities / Total Assets
  • proportion of all assets

  Debt to Equity Ratio

  • Total Liabilities / Total Equity
  • measure the riskiness of capital structure

  Times Interest Earned

  • Operating Profit / Interest Expense
  • ability to operation to provide protection to long-term creditors

  Fixed Charge Coverage

  • Operating profit + Lease payments / Interest Exp. + Lease Paym.
  • capability to cover not only interest but fixed payments
• Return on Investment on Asset (ROA)

  • Net Income / AVG Total Assets or Net Profit Margin x Total Asset Turnover
  • ROA with Interest Bearing
  • Net Income + [Interest + (1 - Tax Rate)] / AVG Total Assets

  Return on Equity (ROE)

  • Net Income / AVG Stockholder Equity
  • ROA and ROE are measure the overall efficiency of the firmin managing its total investment in assets
• Gross Profit Margin

  • Gross Profit / Net Sales
  • show relationship between sales and the cost of products

  Operating Profit Margin

  • Operating Profit / Net Sales
  • overall operating efficiency

  Net Profit Margin

  • Net Income / Net Sales
  • measure profitability

  Cash Flow Margin

  • Cash flow from Operating Act / Net Sales
  • ability to translate sales to cash to enable it to service debt.
• Financial Leverage Index

  • Return on Equity / Return on Assets
• Earning per share (EPS)

  Basic EPS

  Net Income / Weighted AVG number of ordinary shares outstanding

  Diluted EPS

  Net Income (as adjusted) / Weighted AVG number of ordinary shares outstanding and potential diluters
• Price Earning Ratio (P/E)

  • Market Price of ordinary shares / EPS

  Dividend Payout ratio

  • Dividends per share / Earning per share

  Dividend Yield

  • Dividends per share / Market value per share
• Du Pont Disaggregation

  • Managers and investors often perform a detailed analysis of Return on Assets ROAS and Return on Equity(ROB)using the Du Pont Analysis System.
  • facilitates an integrated analysis of the turn over ratios and the profit margin on sales and it shows how the various ratios interactto determinetherateo freturnonassets.
• 1. Transfer Pricing - division make sales to other division affected by transfer price
  2. Depreciation Policy - ROA is very sensitive to depreciation policy.
  3. Net depreciated value of assets - make ROA high
  4. Long-Term Projects vs. Short Term Projects - reduced ROA the division involved
  5. Industry conditions - not only consider ROA but growth rate in sales, profit margin compare to other firm
• GROSS PROFIT VARIATION ANALYSIS

  • evaluation of income statement items is of real significance because the long-run succes
• Increase in Sales

  • Quantity Factor - (change in quantity x selling price last year)
  • Price Factor - (change in price or quantity sold last year)
  • Quantity/Price Factor - (change in quantity x change in selling price)

  Less: Increase in Cost of Sales

  • Quantity Factor - (change in quantity x unit cost last year)
  • Price Factor - (change in unit cost x quantity sold last year)
  • Quantity/Cost Factor - (change in quantity x change in unit cost)

  Total

  Net Increase (Decrease) in Gross Profit
• Gross Profit Variance Analysis Example