Analysis and Interpretation

Analysis and Interpretation

 Liquidity refers to the ability of an entity to convert its assets into cash. Relevant ratios include:

o Current ratio

 What current assets do you have in comparison to current liabilities

 Do you have enough to pay off current liabilities o Quick ratio

o Days debtor’s ratio o Days inventory ratio

 How long inventory sticks on the shelf

 Provide useful information to assist users in making informed decisions relevant to their circumstances

 Information contained in reports are just numbers- difficult to compare in absolute terms o Example: if you have 2 companies that are of different sizes- how do you know which

one is performing better than the other?

 Just because company X has a larger profit than company Z.. does it mean that it is more efficient?

o Difficult to answer by just looking at reports with numbers Fundamental Analysis: YouTube Video

 Process of examining a company’s financial statements to decide whether stock is a good investment

 Information helps determine financial make-up of the company

 Balance Sheet

o Compares Assets to its Liabilities and Owners Equity

o Assets= items the company owns and have the potential to bring the company benefits

 Cash, equipment and property

o Liabilities= debts/accounts that need to be paid

 Has an off-setting asset that keeps its level

 Eg: a loan taken out to by property  the loan is the liability and the property is the asset

o Owners’ equity = amount of assets raised by issuing stock

 Issues stock  Raises money/capital that can be used to fund business expenses

o Assets = Liabilities + Owners Equity

o How a company raises money to fund its assets and whether its over-extended

 Income Statement

o Shows the company’s revenue and expenses

o Expenses- costs associated with running the business

 Operations

 Interest paid on loans

 Taxes

o Net income= revenue – expenses

 Earning of the company

 Handled in two ways:

 Share with shareholders by paying them dividend

 Reinvest earnings into the company- can help their cash position

o

A company with a better cash position is more

prepared to endure economic ups and downs

 Cash Flow Statement

o Statement shows how the company uses its cash to operate the business and make investments

o How much its borrowed from the bank

o Detailed account on how the business generates revenue

o More difficult to manipulate

 A lot of information in financial statement

 Analysis can be tricky – use ratios

 Ratios: help the investor compare stocks

 Determine valuation, profitability and financial strength o Price/Earnings

 Cheapest might not be the best

 Company value is depending on their earnings

 Look beyond the price of the stock

 Net income/ outstanding shares= earnings per share

 Price of stock/ earning per share = P/E ratio o Price/Book Value

o Debt/Equity o Return of Equity o Current Ratio o Net Profit Margin

Users and Decision Making (Textbook)

 Users of financial statements can be categorised as:

o Resource provides

o Recipients of goods and services

o Parties performing and overview or regulatory function

 User groups are interested in different aspects of the entity

 Financial analysis= analytical method in which reported financial numbers are used to form opinions as to the entity’s past and future performance positions

 Statement users generally share a common objective: to evaluate past decisions and make informed decisions about future events

 The decisions that users make vary

o Example: before deciding whether to supply goods and services on credit to an entity

 creditors would be interested in the entity’s ability to pay the debts within the credit period provided

 Financial statements depict historical information

 When making predictions about future events- an evaluation of past events if often the most useful starting point

o Example: assessing the entity’s profitability (defined as the entity’s ability to generate profits from the available resources) will shape an investor’s expectations as to the entity’s future profitability

 Financial analysis involves expressing the reported numbers in relative terms rather than relying on the absolute numbers

 Highlight the strengths and weakness of entities

 Important decision-making tool for evaluating the historical health of an entity and predicting an entity’s future financial wellbeing

Nature and purpose of Financial Analysis (Textbook)

 Financial analysis involves expressing reported numbers in financial statements in relative terms

 Relying on the absolute values contained in the financial statements is not meaningful when trying to evaluate an entity’s past decisions and predict future rewards and risks

 The entity’s absolute dollar values of profit or external debt have increased- but does not necessarily mean that the entity is more profitable or more reliant on debt

 Need to express the reported numbers in relation to other numbers- enabling relationships ot be revealed and the financial statements to tell a story about the entity’s financial health

 Process typically involves comparing figures to:

o The equivalent figures from previous years o Other figures in the financial statements

 The process of comparison can be categorised as horizontal analysis, trend analysis, vertical analysis and ratio analysis

- Fundamental analysis refers to analysing many aspects of an entity to assess the entity, including reviewing the state of the industry in which the entity operates, as well as the entity’s financial statements, its management and governance, and its competitive positioning.

- While fundamental analysis is conducted on historical data and current information - Purpose of the analysis is to make predictions about the entity’s future

- One aspect of fundamental analysis is financial analysis

- When interpreting a ratio- it is important to understand what the ratio is measuring and to compare it to an appropriate benchmark

- An entity’s accounting policy choices and management decisions affect the report numbers and should be taken into consideration when comparing ratios

- Financial analysis adds further meaning to the report numbers- allowing users to make better assessment of an entity’s profitability, efficiency, liquidity, capital structure and market performance

Analytical Methods (Textbook)

 Horizontal Analysis:

o Change in individual financial statement items from period to period o Expressed as a percentage of that same item in the base year

o Every item on the financial statement is reported as a percentage of that base o Focus shifts from absolute to recognition of developing trends

o Compares the reported numbers in the current period with the equivalent numbers for a previous period – usually the immediate preceding period

o Financial statements are usually presented in a two-column format containing the figures for the current reporting period and the figures for the comparative reporting period

o Permits the user to readily calculate the absolute dollar change and the percentage change in the reported numbers between periods

o Dollar change= current period’s number – previous period’s number

o the percentage change cannot be calculated if the equivalent reported figure for the previous year was zero

o care must also be exercised when ascertaining and interpreting the direction of the change

 example: if expenses or cash outflows are greater in the current year than in the previous year- the direction of the change is upwards, but this has a negative rather than positive impact on reported profit or cash flows o Horizontal analysis compares the reported numbers in the current period with the

equivalent numbers for a preceding period.

o This permits the user to readily calculate the absolute dollar change and the percentage change in the reported numbers between periods.

o The dollar change is calculated as the reported number in the current reporting period, less the reported number in the previous reporting period.

o The percentage change is calculated as the dollar change in the reported number between the current and previous reporting periods, divided by the value of the reported item in the previous year.

o Horizontal analysis highlights the magnitude and significance of the dollar changes.

 Trend Analysis:

o Similar to horizontal

o Converts figures to an index measured against a base year

o Tries to predict the future direction of various items on the basis of the direction of various items on the basis of the direction of the items in the past

o To calculate a trend- at least 3 years of data is required

o Trend analysis of a particular item involves expressing the item in subsequent years, relative to a selected base year

 The base year is typically given a value of 100

o Useful in identifying the significance of an item relative to a base amount o Identifying trends is useful in formulating predictions as to future prospects of the

entity

 Vertical Analysis

o Recast each financial statement to express dollar amounts as a percentage of an item or total in the financial statement

o Another method of converting the absolute dollar values in financial statements into more meaningful figures

o Compares financial statement to an anchor item in the same statement

o The anchor item in the balance sheet is total assets, in the income statement it is revenue

o All asset, liability and equity items are expressed as a percentage of total assets, and all income and expense items are expressed as percentage of revenue

o A vertical analysis identifies the importance of an item relative to the anchor item

 Ratio Analysis:

o Ratio= simply a comparison of one item in a financial statement relative to another item in a financial statement- one item is divided by another to create the ratio o Ration analysis= examines the relationship between two quantitative amounts with

the aim of expressing the relationship in ratio or percentage form

o Comparison between these statements Is not always straightforward, because the income statement and statement of cash flows involve flow items that are generated over a period of time

 Flow items= item in the financial statements that generated over a period of time

o The balance sheet reports stock items

 Stock items= item in the financial statement as at a point of time

o 3 step processes

1. Calculate the meaningful ratio by expressing he dollar amount of an item in a financial statement by the dollar amount of another item in a financial statement 2. Compare the ratio with a benchmark

3. Interpret the ratio and seek to explain why it differs from previous years, from comparative entities or from industry averages

o Purpose of the ratio analysis:

 Express a relationship between two relevant items that is easy to interpret and compare

 Categorise ratios into 5 groups

 Profitability ratios

o To asses an entity’s effectiveness and efficiency In earning profits and providing a return for the company and the shareholders

 Efficiency ratio

o Assess how efficiently or how well they are using their assets

 Liquidity ratios

o To assess the firm’s ability to meet its financial obligations on a timely basis

 Capital structure ratios

o Looks at the long-term structure of the business

 Market performance ratios (relevant to companies listed on an organised securities exchange)

o Helps work out the market sentiment towards the company by comparing the company’s financial numbers to its share price

Benchmark:

 Example (JB HiFi)

o Accepted arbitrary standards (rule of thumb)  compare JB HiFi’s ratio to the commonly accepted minimums

o Management budgets/targets  JB HiFi’s actual ratio results compared to JB HiFi’s forecasted results

o Comparison to previous years  compare JB HiFi’s 2015 ratios to JB HiFi’s 2013 and 2014

o Comparison to competitors  Compare JB HiFi’s ratio to electronic retailer The Good Guys ratio

o Industry averages  JB HiFi’s ratio compared to the industry as a whole Ratio Analysis Categories:

 Profitability

o Gross profit margin

 Allows the cost and selling price of inventory to be assessed

 Ratio 74.86%- every 1 dollar of sales 74.86 cents was consumed by cost of sales

 Information is useful to ask questions such as:

 Should alternative suppliers be sought?

o Return on assets

 How effective management has been in employing assets to generate a return

 If there was a return on assets of 15.2%- for every 1 dollar of asset used by management they generated at return/profit of 15.2 cents

o Profit margin

 Profitability of each dollar of sales

 4.97%- business is generating profit of 497 cents for every 1 dollar of sales per period

o Cash flow to sales

 Relative amount of cash flow generated by each sales revenue dollar o Return on equity

 Return on shareholders’ investment

 Return on equity 23.7% = indicate that for every 1 dollar of investment the company would generate a return/profit of 23.7 cents

 Efficiency

o Days in inventory

 How long on average it takes to sell inventory?

 This level of ratio which is considered good or bad – can dependent on the industry that the business is operating in

 Businesses with perishable goods (example: florist) shorter period of time in which they sell they inventory than a business selling luxury cars

o Times inventory turnover

 The number of times on average inventory is sold out during the period

 Higher is better

o Times debtor’s turnover

 Number of times on average that debts are turnover over during the period

 Higher is better o Asset turnover ratio

 Ability of management to use assets to generate sales

 For example: an asset turnover ratio of 3.06 times- indicates that for every dollar of assets employed the business is generating $3.06 of sales in the period

o Days in debtors

 How long on average it is taking for debtor to pay

 Quicker is better

 Can also be linked to the number of days credit a business has offered to its customers

 Liquidity:

o Current ratio

 Indicates the ability of the business to pay of its current liabilities with its current assets

 Example: current ratio of 3.25:1 – indicates the business has $3.25 of current asset to cover every $1 of current liabilities

 Considered a good coverage

o Cash flow ratio

 Businesses ability to cover current obligations from operating activity cash flows

 The higher the better

o Quick ratio

 The ability of the business to cover its current liabilities with its most liquid current assets ONLY

 Inventory is taken out of the ratio- in order to convert inventory to cash you need to sell it and that may take time

 Capital Structure:

o Debt to equity o Debt ratio o Equity Ratio

- ^^^ All indicators of the amount of debt/equity finance the business has o Interest coverage ratio

 Indicates the number of times the business can cover its interest expense from the current periods profits

o Debt coverage ratio

 Links cash flows from operating activities with long term debt

 Market Performance

o Net tangible asset backing per share

 Indicates the book value of the company’s tangible assets per ordinary share on issue

o Dividend per share (DPS)

 Distribution of the company profit in the reporting period via dividends

 Expressed relative to the number of relative ordinary shares on issue

o Operating cash flow per share (CFPS)

 Net cash flow from operating activities that are available to pay dividends to shareholders and fund future investments

o Payout ratio

 Indicates the percentage of profits paid out to ordinary shareholders as dividends

 Important to those investors to purchase shares to receive their return on investment by way of dividends

o Price earnings ratio (PER)

 How much an investor would have to pay in the market for each dollar of earning

 Market price reflects expectations of future performance

 PER- compares present performance with expectation

 High PER  growth companies

 Low PER  stable companies

o Earnings per share (EPS)

 Converts absolute dollar amount of operating profit to a per share basis

 Earnings per share is usually disclosed in newspapers Ratio interrelationships

 Many of the ratios should be viewed together

 Movement in one ratio can be explained by movement in another

 What is a DuPont Analysis? (YouTube)

o Financial ratio based on the return on equity ratio that is used to analyse the company’s ability to increase its return on equity

o Breaks down ROE ratio to explain how companies can increase their return for investors

o ROE- strong measure of how well a company’s management creates value for its shareholders

 Vulnerable to measures that can increase its value – makes stock more risky

 Investors could be duped into thinking an investment is risky when it is not o Looks at 3 main components:

 Profit margin

 Total asset turnover

 Financial leverage Limitations of Ratio Analysis:

 Quality

o Dependent on the quality of the financial statements

o Any errors in the financial statements will be transferred to the calculation of the ratio

 Accounting standards and policy choices

o Comparison with other entities and/or over time- can be problematic o Need to be aware of any differences or chances that have occurred

 Don’t use in isolation

o Other sources of information- financial newspapers, information about companies,

 Historical data