Lesson 6

Analysis of financial statements

Structure

  1. Introduction

  2. Analysis techniques

  3. Balance sheet analysis

  4. Income statement analysis

  5. Return analysis

1. Introduction

  • Analysis of financial statements or financial analysis

  • Goals:

    • to assess the current profitability and operational efficiency of the
      firm as a whole as well as its different departments so as to judge
      the financial health of the firm.
      • to ascertain the relative importance of different components of the
      financial position of the firm.
      • to identify the reasons for change in the profitability/financial position
      of the firm.
      • to judge the ability of the firm to repay its debt and assessing the
      short-term as well as the long-term liquidity position of the firm.

Introduccion II

It studies:

Financial structure:

  • Finance sources

  • Capacity to face debts at maturytiy

Economic structure

  • Investments to carry out the company operation

  • Non-current assets

  • Minimum level of current assets

Introduction III

  • It allows

    • measuring the result of the company decisions

    • adopting measures to improve in the future

  • Limitations:

    • Base on historic data

    • Usually referred at the end of the year

    • Sensitive to accounting manipulations

    • It does not consider inflation effects

Structure

  1. Introduction

  2. Analysis techniques

  3. Balance sheet analysis

  4. Income statement analysis

  5. Return analysis

2. Analysis techniques

  • Horizontal analysis

  • Vertical analysis

  • Ratio analysis

  • Intracompany

  • Intercompany

  • Dynamic

  • Static

  • Balance analysis

  • Income statement analysis

Horizontal analysis

  • Over multiple periods of time

  • Percentage growth

  • Easy to spot trends and growth patterns

  • Also call trend analysis

Vertical analysis

  • Relationships between numbers in a single reporting period (or one moment in time)

Ratio analysis

  • Relative analysis
  • Just a division but it is important to know the definition considered in both numerator and denominator

Intracompany and intercompany analysis

  • Intracompany: Comparison within the company (past or forecasting)
  • Intercompany: Comparison with other companies

Static and dynamic analysis

  • Static: for a given time

  • Dynamic: Throughout time comparing several years

Balance analysis

To assess:

  • Liquidity and solvency

  • Debt

  • Asset management

  • Financial balance

Income statement analysis

  • To determine how the company creates profits and how to improve them

  • It can be used with historical or previsional statements

  • To evaluate sales, operation margin, financial expenses, fixed expenses

  • To determine the break-even-point

Structure

  1. Introduction

  2. Analysis techniques

  3. Balance sheet analysis

  4. Income statement analysis

  5. Return analysis

3. Balance analysis

Equity and Liabilities:

  • Capital employed: resources not required in the short term

  • Capital employed = Equity + Non-current liabilities

  • Assets = Equity + Liabilites

  • Assets = Capital employed + Current Liabilities

Assets:

  • Non-current assets

  • Current assets: Inventory + Receivables + Cash and cash equivalents

Working capital

Working capital:

  • Working capital is the difference between a company’s current assets and its current liabilities, such as accounts payable and debts

  • Commonly used measurement to gauge the short-term health of an organization

Working capital II

  • Negative working capital: current assets < current liabilities

  • Positive working capital: current assets > current liabilities

  • It indicates whether the pool of money a company has, or expects to receive, over the next year is sufficient to meet the short term obligations it also expects to meet during that time

2 min video

Vertical analysis of the balance sheet

  • Working out the percentage of each mass in the balance

  • Easy to plot

  • Balance sheet item / Total assets

Balance ratios

  • Liquidity ratios: measure a company’s ability to pay debt obligations and its margin of safety

  • Debt and Structure ratios: company’s leverage and company’s long-term stability and structure. Debt/Assets

  • Turnover ratios: sales divided by average asset amount. It shows the efficiency on assets utilization

Operation cycles

Liquidity ratios

\[ \text{Liquidity Ratio}=\frac{\text{Current Assets}}{\text{Current Liabilities}} \]

\[ \text{Average Collection Period}=\frac{\text{Average of Trade Receivables}}{Sales}\cdot365 \]

\[ \text{Average Payment Period}=\frac{\text{Average of Payables}}{Sales}\cdot365 \]

Debt and structure ratios

  • Capital structure is how a company funds its overall operations and growth

  • Debt consists of borrowed money that is due back to the lender, commonly with interest expense

  • Equity consists of ownership rights in the company, without the need to pay back any investment

  • The debt-to-equity (D/E) ratio is useful in determining the riskiness of a company’s borrowing practices

\[ \text{Debt Ratio}=\frac{Liabilities}{Equity + Liabilities}\]

\[ \text{Solvency Ratio}=\frac{Assets}{Liabilities} \]

\[ \text{Debt to Equity Ratio}=\frac{Liabilities}{Equity} \]

Structure

  1. Introduction

  2. Analysis techniques

  3. Balance sheet analysis

  4. Income statement analysis

  5. Return analysis

4. Income statement analysis

  • Vertical and horizontal

  • Intracompany and intercompany

  • Main components (relative or absolute)

  • Margins

  • Trends (horizontal: same figure across two or more time frames)

Structure

  1. Introduction

  2. Analysis techniques

  3. Balance sheet analysis

  4. Income statement analysis

  5. Return analysis

5. Return analysis

  • Components from the balance sheet and income statement

  • Relative measure

  • Return on Assets ROA

    • Assets Turnover

    • Sales margin

  • Return on Equity ROE

    • Leverage

Return On Assets

\[ ROA=\frac{EBIT}{Assets}=\frac{EBIT}{Sales}\cdot\frac{Sales}{Assets}=\text{Sales Margin}\cdot \text{Asset turnover} \]

The return sources are:

  • The margin obtained for every Euro in sales

  • The Sales for every Euro invested

To increase returns companys:

  • increase margin

  • sell more

Also ROA = Net income / Assets

Return On Equity

  • Company’s net income / Shareholder’s equity

  • Profits / Equity

  • Gauge of corporation’s profitability

  • The higher the ROE the better a company is converting equity into profits

  • Usually expressed as a percentage

\[ \text{ROE}=\frac{Sales}{Assets}\cdot\frac{EBIT}{Sales}\cdot\frac{Assets}{Equity}\cdot\frac{EBT}{EBIT}\cdot\frac{\text{Net income}}{EBT} \]

\[ \text{ROE}=\text{Assets turnover}\cdot\text{Sales margin}\cdot\text{Financial Leverage}\cdot\text{Tax effect}\]