II. FINANCIAL ANALYSIS

 1. Overview of Financial Analysis (F.A)

    Definitions

      an assessment of the viability, stability, and profitability of a business, sub-business or project.

      F.A involves

-          common size analysis,

-          ratio analysis,

-          trend analysis,

-          industry comparative analysis.

      This permits the valuation analyst

        to compare the subject company to other businesses in the same or similar industry

          By comparing a company’s financial statements in different time periods, the valuation expert can view

            growth or decline in revenues or expenses

            changes in capital structure

            other financial trends

          How the subject company compares to the industry will

            help with the risk assessment

            help determine the discount rate and the selection of market multiples

        to discover trends affecting the company and/or the industry over time

      Based on these reports, management may

        · Continue or discontinue its main operation or part of its business;

        · Make or purchase certain materials in the manufacture of its product;

        · Acquire or rent/lease certain machineries and equipment in the production of its goods;

        · Issue stocks or negotiate for a bank loan to increase its working capital;

        · Make decisions regarding investing or lending capital;

        Other decisions that allow management to make an informed selection on various alternatives in the conduct of its business.

    Goals

      Profitability

        its ability to earn income and sustain growth in both short-term and long-term

        A company's degree of profitability is usually based on the income statement

      Solvency

        ability to pay its obligation to creditors and other third parties in the long-term

        it is based on the company's balance sheet

      Liquidity

        its ability to maintain positive cash flow, while satisfying immediate obligations

        it is based on the company's balance sheet

      Stability

        the firm's ability to remain in business in the long run

        Assessing a company's stability requires the use of both the income statement and the balance sheet, as well as other financial and non-financial indicators.

    Methods

      Financial analyst often compare financial ratios

        Past performance

          Across historical time periods for the same firm

        Future performance

          Using historical figures and certain mathematical and statistical techniques

          Using facts about the present or about one thing or group to make a guess about the future or about the other things or groups

        Comparative performance

          Comparison between similar firms

      These financial ratios face several theoretical challenges:

        They say little about the firm's prospects in an absolute sense

        One ratio holds little meaning

        Seasonal factors may prevent year-end values from being representative

        Financial ratios are no more objective than the accounting methods employed

        They fail to account for exogenous factors like investor behavior that are not based upon economic fundamentals of the firm or the general economy

    Financial analysis is required for many financial management decisions:

2  The Balance Sheet

    is a summary of the financial position at a specific point in time.

    presents the economic resources of an organization and the claims against the resources.

    presents a snapshot of the firm's assets and the sources of the money that was used to buy those assets.

    Book values and Market values

      Book value

        is based on historical or original value;

        is "back-ward looking" measures of value;

        is based on the past cost of the assets.

      Market value

        will generally equal their book values

        measures current values of assets and liabilities;

        is the price at which the shareholders can sell their shares

    Market- versus Book-value Balance Sheet

 3 The Income Statement

    shows how profitable the firm has been during the year.

    reports the organization's financial performance over a specified period of time.

    It summarizes all revenue earned and expenses incurred during a specified accounting period

    can determine its net profit or loss (the difference between revenue and expenses)

    Profit versus Cash Flow

      Profit

      Cash flow

4  The Statement of Cash Flows

    A cash flow statement shows where an institution's cash is coming from and how it is being used over a period of time.

    - Classifies the cash flows into operating, investing and financing activities.

      Cash Flow from operations

        start with net income but adjusts that figure for those parts of the income statement that do not involve cash coming in or going out

        • Operating activities: services provided (income-earning activities).

      Cash provided by investments

        expenditures that have been made for resources intended to generate future income and cash flows.

      Cash provided by financial activities

        resources obtained from and resources returned to the owners,

        resources obtained through borrowings (short-term or long-term) as well as donor funds.

    - Can use either

      • The direct method, by which major classes of gross cash receipts and gross cash payments are shown to arrive at net cash flow

      • The indirect method,

        works back from net profit or loss,

        adding or deducting noncash transactions,

        deferrals or accruals of past or future operating cash receipts or payments,

        items of income or expense associated with investing or financing cash flows to arrive at net cash flow

 5 Taxes

    Corporate Tax

      When firms calculate taxable income they are allowed to deduct expenses.

        These expenses include an allowance for depreciation,interest paid to debt-holders

    Personal Tax

      the dividends and interest payments that companies make to individual are both subject to tax

      Capital gains are also taxed

  6Financial Ratios

    Liquidity Ratios

      are probably the most commonly used of all the business ratios

      show the ability of your business to quickly generate the cash needed to pay your bills.

      are sometimes called working capital ratios

      are

        Current Ratio

          Current assets / Current liabilities.

          looks at your working capital and measures your short-term solvency

          shows the ability of your business to generate cash to meet its short-term obligations.

        Quick Ratio

          (Current assets - Stocks) / Current liabilities.

          gives you a better picture of your ability to meet your short-term obligations, regardless of your sales levels

    Efficiency Ratios

      measure the speed with which current assets are moved through the business in order to improve cash flow

      measure the efficiency of the business in using its fixed assets to achieve the level of turnover.

      are

        Stock Turnover Ratio

          shows how quickly the business sells its stock

          (Cost of Sales) / (Average stock held throughout the year)

        Debtor's Turnover Ratio

          is referred to as debtor's collection period

          shows how long it is taking to collect debts from customers

          (Debtors x 365) /Credit Sale

        Creditor's Turnover Ratio

          referred to as creditors' payment period

          shows how quickly the business pays its creditors

          (Creditors x 365) /Credit Purchases

        Asset Turnover Ratio

          measures the efficiency of use of different groups of assets to produce turnover

          Turnover / Fixed Assets

    Profitability Ratios

      referred to as performance ratios

      measures the level of profitability of the business

      are

        Gross Profit Percentage

          measures the gross profit as a percentage of sales revenue

          (Gross Profit x 100) / Sales

        Mark-up Percentage

          measures the gross profit as a percentage of the cost of sales

          (Gross Profit x 100) / Cost of Sales

        Net Profit Percentage

          expresses the net profit as a percentage of sales

          (Net Profit before tax x 100) / Sales

        Return on Capital Employed (ROCE)

          expresses the net profit as a percentage of the capital invested in the business

          (Net Profit before tax  x 100) / Net Assets

    Solvency Ratios

      measures the ability of your business to survive over a long period of time

      include

        Debt to Owner's equity ratio

          indicates the degree of financial leverage that you are using to enhance your return.

          Total Debt / Owners' Equity

        Debt to Assets ratio

          measures the percentage of assets financed by creditors compared to the percentages that have been financed by the business owners

          Total Debt / Total Assets

  For Class Discussion

  Special Terms