Course Outline. I. Basics of Accounting Selected topics. Financial Statement Analysis. 1. Objectives 2. Financial Ratios

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1 Course Outline I. Basics of Accounting II. Selected topics III. Financial Statement Analysis 1. Objectives 2. Financial Ratios 2.1. Liquidity, cash conversion cycle, cash is king 2.2. Solvency and debt ratio 2.3. Profitability and return on investment 15/04/2014 pag. 1

2 Course Outline I. Basics of Accounting II. Selected topics III. Financial Statement Analysis 1. Objectives 2. Financial Ratios 2.1. Liquidity, cash conversion cycle, cash is king 2.2. Solvency and debt ratio 2.3. Profitability and return on investment 15/04/2014 pag. 2

3 Financial statement analysis 1. Objectives Definition Using financial statements to assess a company s performance Focuses on past performance to predict future performance Objective Different users of the financial statements might be interested in different information. They all however want to make good decisions.

4 Financial statement analysis 1. Objectives different users Objectives Creditors want to know about short-term liquidity and long-term solvency. Short-term liquidity - an organization s ability to meet current payments as they become due (e.g. interest payable A/P) Long-term solvency - an organization s ability to generate enough cash to repay long-term debts as they mature (principal)

5 Financial statement analysis 1. Objectives different users Equity investors are more concerned with returns in the form of dividends and increased market price of the stock. These investors are naturally more interested in profitability. Profits spur both dividends and increased stock prices (= market s assessment of the company future prospects).

6 Course Outline I. Basics of Accounting II. Selected topics III. Financial Statement Analysis 1. Objectives 2. Financial Ratios 2.1. Liquidity, cash conversion cycle, cash is king 2.2. Solvency and debt ratio 2.3. Profitability and return on investment 15/04/2014 pag. 6

7 Financial statement analysis 2. Financial Ratios Financial Ratios The cornerstone of financial statement analysis is the use of ratios. A financial ratio is calculated by dividing one number of the financial statements accounts (numerator) by another number of the financial statement accounts (denominator): it shows the relationship between two numbers Financial ratios are sometimes grouped into categories: Short-term liquidity ratios (incl. efficiency ratios) Long-term solvency ratios Profitability ratios (margin and effectiveness ratios)

8 Financial statement analysis 2. Financial Ratios Financial ComparisonsRatios 2. Financial Ratios - Evaluating Financial ratios are evaluated using three types of comparisons: Time-series comparisons: comparisons of a company s financial ratios with its own historical ratios. Benchmarks: general rules of thumb specifying appropriate levels for financial ratios. Cross-sectional comparisons: comparisons of a company s financial ratios with the ratios of other companies or with industry averages. 15/04/2014 pag. 8

9 Financial Vergaren statement van informatie analysis 2. Financial Ratios Gather information - Central Balance Sheet Office (NBB) (on-line and free consultation of the filed annual accounts; company file (30 ))

10 Vergaren van informatie Financial statement analysis 2. Financial Ratios Gather information

11 Vergaren van informatie Financial statement analysis 2. Financial Ratios Gather information

12 Financial Vergaren statement van informatie analysis 2. Financial Ratios Gather information - Central Balance Sheet Office (NBB) (on-line and free consultation of the filed annual accounts; company file (30 )) - Belfirst cd-rom (for free in the VUB)

13 Vergaren van informatie Financial statement analysis 2. Financial Ratios Gather information

14 Financial Vergaren statement van informatie analysis 2. Financial Ratios Gather information - Central Balance Sheet Office (NBB) (on-line and free consultation of the filed annual accounts; company file (30 )) - Belfirst cd-rom (for free in the VUB) - Graydon commercial report (not free)

15 Vergaren van informatie Financial statement analysis 2. Financial Ratios Gather information

16 Financial Vergaren statement van informatie analysis 2. Financial Ratios Gather information - Central Balance Sheet Office (NBB) (on-line and free consultation of the filed annual accounts; company file (30 )) - Belfirst cd-rom (for free in the VUB) - Graydon handelsrapporten (not free) - CompanyWeb (not free)

17 Vergaren van informatie Financial statement analysis 2. Financial Ratios Gather information

18 Financial Vergaren statement van informatie analysis 2. Financial Ratios Gather information - Central Balance Sheet Office (NBB) (on-line and free consultation of the filed annual accounts; company file (30 )) - Belfirst cd-rom (for free in the VUB) - Graydon handelsrapporten (not free) - CompanyWeb (not free) - Website company (Investor Relations), press,...

19 Activa Vaste Activa Oprichtingskosten Immateriële vaste activa Materiële vaste activa Financiële vaste activa Vlottende activa Vorderingen > 1 jaar Voorraden en bestellingen in uitvoering Vorderingen 1 jaar Geldbeleggingen Liquide middelen Overlopende rekeningen Totaal der activa Liquiditeit Financial statement analysis 2.1. Liquidity Belgium Hoe goed kan een Standard onderneming haar format betalingsverplichtingen op korte termijn nakomen? (enacted How well can by law, a company RD 30th meet January its payment 2001) obligations in the short term? BALANCE SHEET Passiva Eigen vermogen Kapitaal Uitgiftepremies Herwaarderingsmeerwaarden Reserves Overgedragen resultaat Kapitaalsubsidies Voorzieningen en uitgestelde belastingen Voorzieningen Uitgestelde belastingen Schulden Schulden > 1 jaar Schulden 1 jaar Overlopende rekeningen Totaal der passiva

20 Financial 2. Financial statement Ratios analysis 2.1. Liquidity Liquidity How well can a company meet its payment obligations in the short term? Short term liquidity: an organization s ability to meet current payments as they become due. Current Ratio = Current Assets Current Liabilities >1 Assess Quality of the underlying assets (A/R inventories) Quick Ratio = (acid test ratio) Current Assets - Inventories Current Liabilities 15/04/2014 pag. 20

21 Financial 2. Financial statement Ratios analysis 2.1. Liquidity Liquidity Quality of underlying assets efficiency ratios Inventories: might be slowmoving obsolete. It is important to know how fast inventory is sold. How many times the inventory is renewed during the year Avg. inventory turnover = Avg. inventory period = COGS Avg. inventory 365 Avg. inventory turnover

22 Financial statement analysis 2.1. Liquidity Quality of underlying assets efficiency ratios A/R (Accounts Receivable): might be using long credit terms uncollectible. It is important to know how fast A/R are converted into cash How long does it take to collect money after a sale Avg. daily sales = Sales 365 days Avg. collection period = Average A/R Avg. daily sales

23 Financial statement analysis 2.1. Operating and cash conversion cycle Receipt inventory Sale (on credit) Cash receipt From Sale Operating cycle = The time span during which goods and services enter the company and the company receives cash for it from customers <=> 1 year Avg. Inventory period + Avg. collection period Avg. Payment period Cash conversion cycle = the time span during which cash is used to acquire goods and services, which in turn are sold to customers, who in turn pay for their purchases, with cash cfr. working capital needs

24 Financial statement analysis 2.1. Operating and cash conversion cycle Example Receipt inventory Sale (on credit) Cash receipt From Sale Operating cycle = The time span during which goods and services enter the company and the company receives cash for it from customers <=> 1 year Avg. Inventory period + Avg. collection period Avg. Payment period Cash conversion cycle = the time span during which cash is used to acquire goods and services, which in turn are sold to customers, who in turn pay for their purchases, with cash cfr. working capital needs

25 Financial statement analysis 2.1. Liquidity Quality of underlying assets efficiency ratios A/P (Accounts Payable): how fast are A/P (and other operating payables e.g. payroll payables) paid with cash Avg. daily purchases = Purchases 365 days EI = BI + P COGS P = COGS + EI - BI Avg. payment period = Avg. A/P Avg. daily purchases

26 Financial statement analysis 2.1. Operating and cash conversion cycle Receipt inventory Sale (on credit) Cash receipt From Sale Operating cycle = The time span during which goods and services enter the company and the company receives cash for it from customers <=> 1 year Influence crisis? Avg. Inventory period + Avg. collection period Avg. Payment period Cash conversion cycle = the time span during which cash is used to acquire goods and services, which in turn are sold to customers, who in turn pay for their purchases, with cash cfr. working capital needs

27 Financial Graydon statement Belgium analysis 2.1. Payment behaviour of Belgian Companies Graydon-betaalindex Source: Graydon (2014) Studie Betaalgedrag

28 Financial Graydon statement Belgium analysis 2.1. Payment behaviour of Belgian Companies Graydon-betaalindex Source: Graydon (2014) Studie Betaalgedrag

29 Financial statement analysis 2.1. Graydon Payment behaviour Belgium of Belgian Companies More Failures! # Faillissementen Bron: Graydon (2013) Jaarrapport 2013: Evoluties in het Belgische bedrijvenlandschap

30 Financial statement analysis 2.1. Payment behaviour of Belgian Companies Cash is king?! Some rounded figures ( entities companies 2/3 BVBA 1/3 NV sole propriotorship failliet (1/80) BVBA (1/54) BVBA (1/44) NV (1/104) NV (1/86) (1/250) (1/228) 1/4 failures Due to late or non-payment!!

31 Financial statement analysis 2.1. Example Colruyt 4/2013 3/2014 Receipt inventory Sale (on credit) Cash receipt From Sale Operating cycle = The time span during which goods and services enter the company and the company receives cash for it from customers 26 <=> 1 year 18 Avg. Inventory period + Avg. collection period -6 Avg. Payment period 50 Cash conversion cycle

32 Financial statement analysis 2.1. Example Clicktouch 1/1/ /12/2013 Receipt inventory Sale (on credit) Cash receipt From Sale Operating cycle = The time span during which goods and services enter the company and the company receives cash for it from customers <=> 1 year Avg. Inventory period + Avg. collection period Avg. Payment period Cash conversion cycle

33 Financial statement analysis Liquiditeit Solvability Example Clicktouch Belgium Hoe goed kan een Standard onderneming haar format How 1/1/2013 well a company 31/12/2013 can meet its long-term commitments (debt and (enacted interest)? by law, RD 30th January 2001) betalingsverplichtingen op korte termijn nakomen? Activa Vaste Activa Oprichtingskosten Immateriële vaste activa Materiële vaste activa Financiële vaste activa Vlottende activa Vorderingen > 1 jaar Voorraden en bestellingen in uitvoering Vorderingen 1 jaar Geldbeleggingen Liquide middelen Overlopende rekeningen Totaal der activa BALANCE SHEET Passiva Eigen vermogen Kapitaal Uitgiftepremies Herwaarderingsmeerwaarden Reserves Overgedragen resultaat Kapitaalsubsidies Voorzieningen en uitgestelde belastingen Voorzieningen Uitgestelde belastingen Schulden Schulden > 1 jaar Schulden 1 jaar Overlopende rekeningen Totaal der passiva = = Current Ratio = Current Assets Current Liabilities = 1,90 Quick Ratio= Current Assets Inventories Current Liabilities = 1,08

34 Balance Sheet 1/1/X2 Financial statement analysis 2.1. Cash is king Relationship Retained earnings: between the link between the balance Balance sheet and Sheet the / Income income statement / Statement of cash flows 3. Understanding financial statements Balance Sheet 31/12/X2 Assets Owners equity Assets Paid-in capital Cash 1/1 Cash 31/12 RE 1/1 Liabilities Owners equity Paid-in capital RE 31/12 Liabilities Income statement 1/1/X2 31/12/X2 Revenues 1/1-31/12 - Expenses 1/1-31/12 RE 1/1 + net income 1/1-31/12 Dividends = RE 31/12 Accrual Matching Statement of Cash Flows 1/1/X2 31/12/X2 cash 31/12 = cash 1/1 + net cashflow 1/1-31/12 Cash 15/04/2014 pag. 34

35 Financial Relationship statement between analysis 2.1. Cash is king Balance Sheet / Income statement / Statement of cash flows The Statement of Cash Flows is simply a statement of all the cash received or paid during the year Cash Flow Net cash inflow (outflow) from operating activities Net cash inflow (outflow) from investing activities Net cash inflow (outflow) from financing activities Net increase (decrease) in cash Cash at beginning of year Cash at end of year $m x (x) x (x) x (x) x (x) x $x

36 Financial Relating statement Cash analysis Flow 2.1. Cash is king and Net Income Relating Cash Flow and Net Income Four possible combinations of net income and cash flows exists. Relationship Cash flow from operations + + Net income + + Four possible situations: Situation 1 confirms the profitability of the company. Situation 2 can occur where a company has large noncash expenses such as depreciation. Situation 3 is often an indication of trouble but may also be an indication of a rapidly growing company. Situation 4 confirms the lack of profitability of the company.

37 Course Outline I. Basics of Accounting II. Selected topics III. Financial Statement Analysis 1. Objectives 2. Financial Ratios 2.1. Liquidity, cash conversion cycle, cash is king 2.2. Solvency and debt ratio 2.3. Profitability and return on investment 15/04/2014 pag. 37

38 Activa Vaste Activa Oprichtingskosten Immateriële vaste activa Materiële vaste activa Financiële vaste activa Vlottende activa Vorderingen > 1 jaar Voorraden en bestellingen in uitvoering Vorderingen 1 jaar Geldbeleggingen Liquide middelen Overlopende rekeningen Totaal der activa Financial statement analysis Liquiditeit 2.2. Solvability Belgium Hoe goed kan een Standard onderneming haar format How well a company can meet its long-term commitments (debt and (enacted interest)? by law, RD 30th January 2001) betalingsverplichtingen op korte termijn nakomen? BALANCE SHEET Passiva Eigen vermogen Kapitaal Uitgiftepremies Herwaarderingsmeerwaarden Reserves Overgedragen resultaat Kapitaalsubsidies Voorzieningen en uitgestelde belastingen Voorzieningen Uitgestelde belastingen Schulden Schulden > 1 jaar Schulden 1 jaar Overlopende rekeningen Totaal der passiva

39 Financial statement analysis 2. Financial Ratios 2.2. Solvability Solvency Long term solvency: an organization s ability to generate enough cash to repay long-term debts as they mature!! Definition of solvency ratio!! Total debt to total assets = Total liabilities Total assets 60% Total debt to equity = Total liabilities Stockholders equity 15/04/2014 pag. 39

40 Financial statement analysis Solvency 2.2. Solvability The prudent use of debt is a major part of intelligent financial management. Debt financing is more attractive than equity financing because: Interest payments are deductible for income tax purposes, but dividends are not deductible. The ownership rights to voting and profits are kept by the present shareholders. using borrowed money at fixed interest rates might enhance the rate of return on common equity (= financial leverage, trading on the equity)

41 Financial statement analysis Trading on the Equity 2.2. Solvability Trading on the Equity EPS Equity + Liab Equity Advantage equity Advantage liabilities Indifference point EBIT

42 Financial statement analysis 2.2. Solvability on the Equity Trading on the Equity Benefits: Larger returns to the common shareholders, as long as overall income is large enough to cover the increased interest payments Interest coverage = EBIT I Example Clicktouch: Interest coverage = = 15

43 Financial statement analysis Optimal debt ratio? 2.2. Solvability Industry related! Optimal debt ratio? Industry related! Industry with high level of tangible assets (mortgage!); Bv. Paperindustry (debt / SHE: 1,36) Pharmaceutical industry (debt / SHE:,079) [Kester (1986)] Industry with stable operating income (EBIT);

44 Financial statement analysis Liquiditeit 2.2. Solvability Example Clicktouch Belgium Hoe goed kan een Standard onderneming haar format How 1/1/2013 well a company 31/12/2013 can meet its long-term commitments (debt and (enacted interest)? by law, RD 30th January 2001) betalingsverplichtingen op korte termijn nakomen? Activa Vaste Activa Oprichtingskosten Immateriële vaste activa Materiële vaste activa Financiële vaste activa Vlottende activa Vorderingen > 1 jaar Voorraden en bestellingen in uitvoering Vorderingen 1 jaar Geldbeleggingen Liquide middelen Overlopende rekeningen Totaal der activa BALANCE SHEET Passiva Eigen vermogen Kapitaal Uitgiftepremies Herwaarderingsmeerwaarden Reserves Overgedragen resultaat Kapitaalsubsidies Voorzieningen en uitgestelde belastingen Voorzieningen Uitgestelde belastingen Schulden Schulden > 1 jaar Schulden 1 jaar Overlopende rekeningen Totaal der passiva = Total debt to total assets = Total Debt Total Assets = = 0,42 Total debt to total equity = Total Debt Shareholders equity = 0,81

45 Course Outline I. Basics of Accounting II. Selected topics III. Financial Statement Analysis 1. Objectives 2. Financial Ratios 2.1. Liquidity, cash conversion cycle, cash is king 2.2. Solvency and debt ratio 2.3. Profitability and return on investment 15/04/2014 pag. 45

46 Financial statement analysis 2. Financial Ratios Profitability 2.3. Profitability 1. Profitability profit rate!!definition of profit rate Gross Profit %= Gross profit Sales EBIT-to-sales = Return on sales= EBIT Sales Net income Sales 15/04/2014 pag. 46

47 Financial statement analysis 2.3. Profitability Gross profit percentage Gross Profit Percentage Often the nature of the business of a company affects the gross profit as compared to other types of companies (service vs. production company). Retailers often lower their gross profit margins and selling prices and hope that the lower selling prices will increase sales volume enough to compensate for the lower gross profit. Industries with higher gross profit percentages tend to have the lowest inventory turnover.

48 Financial statement analysis 2.3. Profitability 2. Profitability Rates of return Rate of return on investment (operating performance) - evaluates the overall success of an investment by comparing what the investment returns with the amount of investment initially made ROI 15/04/2014 pag. 48

49 Financial statement analysis 2.3. Profitability Definition! Income may be defined differently for alternative purposes. Net earnings Earnings before interest and taxes (EBIT) Invested capital may also be defined differently. Stockholders equity Total capital provided by both debt and equity sources 15/04/2014 pag. 49

50 2. 2. Financial Financial Ratios Ratios Financial statement analysis 2.3. Profitability Profitability Profitability Definition! Rate of return on Equity (Investor in common stock): Return on Equity (ROE) Rate of return on Assets (Lender): Return on Assets (ROA) How effectively does the company uses its total assets to generate returns for all suppliers of capital? 15/04/2014 pag. 50

51 2. 2. Financial Financial Ratios Ratios Financial statement analysis 2.3. Profitability Profitability Profitability Definition! Rate of return on Assets (Lender): Return on Assets (ROA) How effectively does the company uses its total assets to generate returns for all suppliers of capital? Return on assets (ROA) = EBIT Sales x Sales Average total assets Return on assets (ROA) = Profit Margin x Rotation total assets 15/04/2014 pag. 51

52 15/04/2014 pag. 52 Thank you for your attention!

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