1. The document discusses analyzing financial statements through common-size analysis and financial ratios. Common-size statements express figures as percentages of totals to compare changes over time and between companies.
2. Key liquidity, activity, and profitability ratios are defined to evaluate a company's short-term solvency, asset management efficiency, leverage, and overall performance. Current, quick, and cash flow liquidity ratios assess short-term debt paying ability.
3. Receivables, inventory, and fixed asset turnover ratios measure liquidity and efficiency in managing specific assets. Average collection and sale periods evaluate receivables and inventory management.
1. The document discusses analyzing financial statements through common-size analysis and financial ratios. Common-size statements express figures as percentages of totals to compare changes over time and between companies.
2. Key liquidity, activity, and profitability ratios are defined to evaluate a company's short-term solvency, asset management efficiency, leverage, and overall performance. Current, quick, and cash flow liquidity ratios assess short-term debt paying ability.
3. Receivables, inventory, and fixed asset turnover ratios measure liquidity and efficiency in managing specific assets. Average collection and sale periods evaluate receivables and inventory management.
1. The document discusses analyzing financial statements through common-size analysis and financial ratios. Common-size statements express figures as percentages of totals to compare changes over time and between companies.
2. Key liquidity, activity, and profitability ratios are defined to evaluate a company's short-term solvency, asset management efficiency, leverage, and overall performance. Current, quick, and cash flow liquidity ratios assess short-term debt paying ability.
3. Receivables, inventory, and fixed asset turnover ratios measure liquidity and efficiency in managing specific assets. Average collection and sale periods evaluate receivables and inventory management.
1. The document discusses analyzing financial statements through common-size analysis and financial ratios. Common-size statements express figures as percentages of totals to compare changes over time and between companies.
2. Key liquidity, activity, and profitability ratios are defined to evaluate a company's short-term solvency, asset management efficiency, leverage, and overall performance. Current, quick, and cash flow liquidity ratios assess short-term debt paying ability.
3. Receivables, inventory, and fixed asset turnover ratios measure liquidity and efficiency in managing specific assets. Average collection and sale periods evaluate receivables and inventory management.
Jeanlyn Domingo Common-size financial statements translate peso amount to percentages, which indicates the relative size of an item in proportion tho the whole. Common-size statements of financial position show asset, liabilities, and owners’ equity as percentage of total assets while common-size income statements express revenue and expenses as a percentage of sales revenues. The preparation of common-size statements is know as vertical analysis.
Purposes
Common-size statements also known as “Component percentage” or”100 percent” statements
enable to analyst to:
1. Comprehend or visualized the changes in individual items that have taken place from year to year in relation in the total assets, total liabilities ans owners’ equity or net sales.
2. Compare statements of two or more companies or statement of one company with the statements of an entire industry and evaluate their current financial position and operating results.
3.
Guidelines in the Interpretation of Common-size Statements
Statement of Financial Position
1. A common-size statement if financial position shows the percent of total assets
that has been invested in each type or kind of asset. These percentage may be compared with those of a competitor or the industry to determine whether or not firm has over or under-invested in one or more of its assets. This should however, be supplemented by turn over or other statistics before final conclusion can be drawn.
2. The common-size statement will also show the distribution will also show the distribution of liabilities and equity, I.e., the sources of the capital invested in the assets. This will indicate whether or not the company is highly levered or too large a percentage of the total assets have been obtained from creditors. Debt pressure for he company and a low margin of safety for creditors may also be revealed.
3. The percentage of current assets may also be related to the percentage of
current liabilities to determine debt-paying capacity of the company.
Income Statement
1. The common-size income statement shows the amount or percentage of the
sales that has been absorbed by each individual cost or expense item and the percentage that remains as net income.
2. A comparison of year-to-year income statement common-size ratios will show
whether a larger or smaller relative amount of net sales was used to meet particular costs or expenses. These percentages may also be compared with a competitor’s statements to determine in order effect a higher profit margin. Financial Ratio Analysis
A financial ratio is a comparison in friction, proportion, decimal or percentage form of two
significant figure taken from financial statements. It expresses the direct relationship between two or more quantities in the statement of financial position and income statement of a business firm.
Purpose
Through ratio analysis, the financial statements user comes into possession of measures which provide insight into the profitability of operations, the soundness of the firm’s short-term and long-term financial condition and the efficiency with which management has utilized resources entrusted to do it.
Limitations of Financial Ratios
1. Ratios must be used only as financial tools, that is, as indicators of weakness or strength or not to be regarded as good or bad per se.
2. Financial ratios are generally computed directly from the company financial statements, without adjustment. Conventional financial statements prepared in accordance with PFRS have a number of weaknesses that managers must consider if the ratio as are to be meaningful.
3. Ratios are a composite of many different figures - some covering a time period, others an instant time and still others representing averages.
4. Ratios to be meaningful should be evaluated with the use of certain yardsticks. The most common of these are:
a. Company’s own experience (prior years)
b. Other companies in the same industry (industry average)
c. A standard set by management (a budget)
d. Rules of thumb
Financial Ratio Analysis
Liquidity ratios are ratios that measures the firm’s ability to meet cash needs as they arise.
Activity ratios are ratios that measure the liquidity of specific assets and efficiency in managing assets such ad accounts receivable, inventory and fixed assets.
Leverage ratios are ratios that measures the extent of a firm’s financing, with debt relative to equity and its ability to cover interest and other fixed charges such as rent and sinking fund payments.
Profitability ratios are ratios that measures the overall performance of the firm and its efficiency managing assets, liabilities and equity. I. Analysis of Liquidity or Short-term Solvency
Current Ratio
Formula: Current Assets
Current Liabilities
Current ratio is widely regarded as measure of short-term debt-paying ability. Current liabilities are used the denominator because they are considered to represent the most urgent debts requiring retirement within one year or one operating cycle. A declining ration could indicate a deteriorating financial condition or it might be the result of paring of obsolete inventories or other stagnant current assets. An increasing ratio might be the result of an unwise stock piling of inventory or it might indicate an improving financial situation. The current ratio is useful but tricky to interpret and therefore, the analyst must look closely and the individual assets and liabilities involved.
The acid-test (quick) ratio is much more rigorous test of a company’s ability to meet its short-term debts. Inventories are prepared expenses are excluded from total current assets leaving only the more liquid assets to be divided by current liabilities. This is designed measure how well a company can meets its obligations without having to liquidate or depend too heavily on its inventory. Since inventory is not an immediate source of cash and may nit even be saleable in times of economic stress, it is generally felt that to be properly protected, each peso of liabilities should be backes by at least P1 of quick assets.
Cash-Flow Liquidity Ratio
Formula: Cash+Marketable Securities+
Cash Flow from Operating Activities
Current Liabilities
The cash flow liquidity ratio considers cash floe from operating activities )from the statement of cash flows) in addition to the truly liquid assets, cash and marketable securities. II. Analysis of Assets Liquidity and Asset Management Efficiency
Accounts Receivable Turnover
Formula: Net Sales*
Average Account Receivable balance
The accounts receivable turnover roughly measures how many times a company’s accounts receivable have been turned into cash during the year.
Average Collection Period
Formula: 365
Accounts Receivable Turnover
Or
Average Accounts Receivable
Average daily sales
The average collection period helps evaluate the liquidity of accounts receivable and the firm’s cedit policies. The long collection period may be a result of the presence of many old accounts of doubtful collectibility, or it may be result of poor day-today credit management such as inadequate checks on customers or perhaps no follow-ups are being made on show accounts. There could be other explanations such as temporary problem caused by a depressed economy.
Inventory Turnover
Formula: Cost of good sold
Average Inventory balance
The average turnover measures the efficiency of the firm in managing and selling inventory. It is computed dividing the cost of good sold by the average level of inventory on hand. The ratio is sometimes calculated with net sales as the numerator and the average level of the inventory as the denominator.
Average Sale Period
Formula: 365 days
Inventory turnover
The number of days being taken to sell the entire inventory one time(called the average sale or conversion period) is computes by dividing 365 days by the inventory turnover period. Generally, the faster inventory sells, the fewer the finds are tied up in inventory and more profits are generated.
Fixed Asset Turnover
Formula: Net Sales
Average net property, plant and equipment
The fixed asset turnover is another approach to assessing management’s effectiveness on generating sales form investments in fixed assets particularly for a capital-intensive firm.
Total Asset Turnover
Formula: Net sales
Average Total Assets
The total asset turnover is a measure of the efficiency of management to generate sales and thus earn more profit for the firm. When the asset turnover ratios are low relative to the industry of the firm’s historical record. It could mean that either be investment in assets is too heavy or sales are sluggish. They may however be justification for the low turnover.
III. Analysis of Leverage : Debt Financing and Coverage
Debt ratio
Formula: Total Liabilities
Total Assets
The debt ratio measures the proportion of all assets that are financed with debt. Generally, the higher the proportion of debt, the greater the risk because creditors must be satisfied before owners in the event of bankruptcy. The use debt involves risk because debt carries a fixed obligation in the form of interest charges and principal repayment. Failure to satisfy the fixed charges associated with debt will ultimately result in bankruptcy.
Debt Equity Ratio
Formula: Total Liabilities
Total Equity
The debt equity ratio measures the riskiness of the firm’s capital structure in terms of relationship between the funds supplied by creditors (debt) and investors (equity).
Times Interest Earned
Formula: Operating profit
Interest Expense
Times interest earned ratio is the most common measure of the ability of a firm’s operations to provide protection to long-term creditors. The more times a company can cover its annual interest expense from operating earnings, the better off will be the firm’s investors.
Fixed Charge coverage
Formula: Operating Profit + Lease payments
Interest Expense + lease payments
The fixed charge coverage the firm’s coverage ability to cover not only interest payments but also the fixed payment associated with leasing which must be met manually. This ratio is particularly important for firms that operate extensively with leasing arrangements, whether operating leases or capital leases.
IV. Operating Efficiency and Profitability
Gross Profit Margin
Formula: Gross Profit
Net Sales Gross profit margin which shows relationship between sales and the cot of product sold, measures the ability of a company both to control costs and inventories or manufacturing of products and to pass along price increases through sales to customers.
Operating Profit Margin
Formula: Operating profit
Net sales
The operating profit margin is a measure of overall operating efficiency and incorporated all of the expenses associated with ordinary or normal business activities.
Net Profit Margin
Formula: Net Income
Net sales
Net profit measures profitability after considering all revenue and expenses, including interest, taxes and non-operating items such as extaordianry items, cumulative effect accounting chaged, etc.
Cash flow Margin
Formula: Cash flow from operating activities
Net Sales
Cash flow margin in another important measure or perspective on opersting performance. This measures the ability of the firm to translate sales to cash to enable it ti service debt, pay dividends or invest in new capital sales.
Return on Investment on Assets (ROA)
Formula: Net Income
Average Total Asset
If the firm has interest-bearing debt, ROA is computed using the following formula: Net Income
Average total asset
Return on Equity (ROE)
Formula: Net Income
Average stockholer equity
Or
Return on Assets x Financial Leverage or Equity Multiplier*
*Equity Multiplier = 1
Equity ratio
Return on Assets and Return on equity are two ratios that measures the overall efficiency of the firm in mangaing its tiatal investment in assets and in generating return to shareholders. These ratios indicate the amount of profit earned relative to the level of investment of common shareholders.
Financial leverage is computed as follows Return on equity
