Financial statement analysis

From Virbus

Financial statement analysis – Ratio Analysis

[edit] 1 Summary

Financial statement analysis is one of the main techniques to analyse the financial performance and stability of an organization. Much of the analysis is conducted through the use of ratios. This is a reason that we also name it ratio analysis. In this case two distinct perspectives of conducting a financial analysis on the year-end accounts, which are important for decision making are represented. First, the profit performance of a company and second the financial stability of the company.

[edit] 2 Why should you use it?

Financial statement analysis and the ratios, which are conducted through it, provide managers important information for analysing an organization’s performance and for making decisions. It helps managers to make decisions on:

• how to appraise the profit performance of a company and
• how to appraise the financial stability of the company.

As profit is the main objective of any company, the financial statement analysis and the associated ratios are very important for the managers of any organization.

[edit] 3 Why has it been developed and who developed it?

[edit] 4 When should you use it?

Financial statement analysis and the financial statement indicators are mostly conducted on the basis of the year end accounts, but for the purpose of the decision making process, it can be conducted also in a shorter period of time, for example, quarterly or monthly.

Managers use it when they have to make a decision concerning profit performance and/or the financial stability of the company.

[edit] 5 How does it work?

The basis for financial statement analysis is the year-end financial statements (P&L statement and Balance sheet). On the basis of this information, particular ratios are calculated that show the profit performance or the stability of the company.

[edit] 5.1 PROFIT PERFORMANCE INDICATORS/RATIOS

The fundamental indicator of performance represents a return on investment (ROI). If you are limited to one ratio in an appraisal of a company’s performance, you should most likely use ROI.

The basic ROI formula is:

Return on investment (ROI) = EBIT/Total Assets (EBIT = Earnings before interests and taxes)

ROI shows us, how much return (profit) from the assets available has been generated by the company management’s performance in a certain period of time. The higher the ratio is, the better performance is.

To determine an appropriate level of profit (see the P&L statement layout) the item earnings before interest and tax (EBIT) on the P&L statement is considered. Why? This is because EBIT captures the operating performance of a company, as interest expense relates to a financing decision which is mostly outside the influence of the hotel general manager.

The ROI formula can be dissected into the two underlying ratios, profit margin and asset turnover. Following this dissection, the formula for ROI is:

ROI = EBIT/Revenue x Revenue/Total assets

          Profit margin               Asset turnover

This formula is widely known as the “Dupont formula”, as its use was first recorded in the Dupont Company in the USA. It is highly important for the decision making process because it provides the basis for a systematic analysis of ROI under two headings:

• Profit margin
• Asset turnover.

Through this dissection of the ROI formula, we can determine whether the changes in ROI (decrease or increase) stem from a decrease/increase in the company profit margin or its assets turnover or in a combination of both.

If the net profit margin is down from last year, we can work systematically through the P&L statement, picking up all profit figures provided (gross profit, EBIT, net profit after tax) and comparing them to revenue. See the following example:

The first profit, which we can calculate is gross profit. It shows us difference between sales revenue and costs of sales.

Gross profit = Sales revenue – Costs of sales

Gross profit margin is therefore calculated as follows:

Gross profit margin (GPM) = Gross profit / Revenue

Gross profit margin is affected by two variables:

• The price of product or service sold
• The cost of product or service produced or provided.

The GPM is a useful indicator of the primary operating efficiency of the company. It can indicate the effectiveness of the business’s marketing policy trough the price that can be obtained for its products or service, and it can indicate the efficiency of the business in producing, procuring or providing those products or services. It is also a valuable indicator for making comparisons between businesses as the GPM of two businesses within the same market sector are likely to be similar. Where any significant differences are observed, they would be the result of differences in marketing strategy or the cost structures of the products or services they produce.

The GPM would be expected to remain stable over time, despite changes in the volume of sales, as prices in relation to costs would probably not change significantly. When GPM do change from period to period, the possible reasons for this are as follows:

• Change in pricing strategy: offering discounts.
• Change in cost of product or service: new cheaper supplier, change in production methods, bulk-buying discounts.

Coming back to our example on how to identify the changes in overall margin and its influence on changes in ROI, let’s look at the following example: If the gross profit margin is similar to that of last year, the conclusion can be that the lower overall margin has not resulted from a change in the ratio of selling price to the cost of sales. The reason for the decline must lie in a relative increase in selling and general administration costs as these represent the two expense categories after gross profit and before EBIT in the P&L statement. Here the distinction between fixed and variable costs comes into account. As already mentioned the GPM is not likely to vary over time or with respect to sales volume. This is because the costs of sales are mainly variable costs. What this means is that if sales increase, these costs will increase proportionally. But this is not the case with respect to overhead costs – rents, insurances, salaries. These costs are largely fixed and they depend on time and not on activity or sales level. This means that a business which is expanding within the short term is likely to see a net profit margin that increases with sales volume.

By taking this approach of moving down the P&L statement, comparing every level of the profit to revenue, we can isolate the category of expense that has caused a change in the overall profit margin. On this basis, we can than make an appropriate decision to improve future performance.

If all the profit margins are similar to those of last year, then the reason for change in ROI must be in changes of the total asset turnover ratio. In this case, we take an approach similar to that of calculating profit margins. We work systematically through the balance sheet in order to find that group of assets that causes the changes in total asset turnover ratio. Keeping in mind that whenever we use the term turnover, we are comparing an asset to revenue, we compute each turnover such that we divide revenue by a particular group of assets. The exemption is inventory turnover, where we use cost of sales instead of revenue. When computing turnover ratios, we take the average balance of the asset account throughout the year rather than year-end balances of the assets accounts. This approach gives us more realistic results because the assets accounts normally change from day to day during the year and it is therefore not necessary that the year–end assets account gives us a correct picture of available assets during the year (Example: It could be that at the year-end, the assets account is twice as big as it was normally during the year because of a special event starting the following day and therefore the company needs more stocks than usual. In this case, computed turnover is lower than in the other months and it won’t reflect the real situation in the company’s performance).

Each turnover ratio tells us how “hard” the particular asset has “worked” to generate revenue. Or, in other word.s this ratio measures the profit earned on the employment of a particular group of assets. For this reason, the turnover ratios are frequently referred to as efficiency ratios. Most widely computed turnover ratios are:

• Accounts receivable turnover (ART)

ART = Credit sales / average balance of accounts receivable

Because it is easier to understand the figures coming out of calculating this ratio, it is most commonly converted into a number of days by dividing the number of days in the year by the ART.

Average number of days to collect accounts receivable = 365 days / ART

This ratio shows us how many days we need to collect the accounts receivable. If the ART is decreasing, the average number of days to collect accounts receivable will be increasing. This means a worsening efficiency of the company’s performance. The managers should attempt to increase the accounts receivable turnover. But here he has to have in mind that if the accounts receivable increases, the company is on average extending less credit to their customers. If other hotels are extending longer periods of credit, this could result in the loss of some sales.

• Inventory turnover

Inventory turnover = Cost of sales / average balance of inventory

Similar to accounts receivable turnover, inventory turnover is usually converted into the average numbers of days that inventory is held.

Average number of days inventory held = 365 days / inventory turnover

This ratio shows us how many days the inventory is held in the company. The lower ratio means better efficiency of the company’s performance and has a positive impact on increasing ROI. But, on the other hand, we have to be careful when making decisions to improve the company’s performance by trying to decrease our stocks and through that to increase the inventory turnover. If the inventory turnover becomes very high, we might experience stock-outs, which could result in lost sales and loss of customer goodwill.

• Fixed asset turnover.

Fixed asset turnover = Revenue / average balance fixed assets

Fixed asset account balances do not tend to be as volatile as accounts receivable and inventory accounts balances. Nevertheless, due to the large relative size of fixed assets in hotels, a small percentage movement can have a significant impact on total asset turnover. As in the other two turnover ratios, we can compute a turnover for every group of fixed asset i.e. buildings, equipment.

• Different types of ROI

ROI is a generic term that can be tailored to fit many different situations. Its exact calculation depends on the perspective being taken in an analysis. The following is the list of some types of ROI that can be used to assess a company’s performance:

• Return on assets employed
• Return on assets available
• Return on long-term funds
• Return on equity

Assets employed, assets available, long-term funds, equity are all types of investment. If we wish to judge the performance of a manager who has been placed in charge of a group of assets that include some assets which, for some reasons, he cannot currently employ (for example: some rooms are in the process of refurbishment), we might like to compare EBIT to assets employed and not assets available. The main interest of shareholders is earning/profit on shareholder’s equity. In this case we would rather compare net profit after tax to shareholder’s equity.

[edit] 5.2 FINANCIAL STABILITY INDICATORS/RATIOS

Analysis of financial stability can be broken into short-term and log-term perspectives. Appraisal of a company’s short-term financial stability is often named liquidity analysis, while the long-term stability is often called solvency analysis.

[edit] 5.2.1 Liquidity analysis

The analysis of liquidity concerns assets that in the normal course of business will be converted to cash, sold or consumed within one year (current assets) and also liabilities that are due for payment within a year (current liabilities). We can calculate many liquidity indicators. One indicator is “working capital”, which is computed as a difference between current assets and current liabilities. But this indicator does not provide a sound basis for comparison across companies of varying size. More widely used measures of liquidity are the current asset ratio and the quick asset ratio (called also the acid test ratio).

Current asset ratio = Current assets / Current liabilities

Current asset ratio shows us whether the company’s assets will cover its liabilities that will fall due for payment in the next 12 months. If the value of ratio is higher than 1, the company will manage to cover all due for payment liabilities.

Acid test ratio = (Current assets – Inventory – Prepaids) / Current liabilities

In this case we exclude inventory and prepaids from current assets because they are held for some time in business prior to their conversion into cash.

In the hotel sector, the current asset ratio is more appropriate than the acid test ratio to appraise short-term liquidity due to the relatively “liquid” nature of most of its inventory.

While the hotel manager would certainly be concerned to see the current or acid test ratio fall below 1, it is difficult to provide an optimal current or acid test ratio. A lender to the hotel would like to see high liquidity ratios as this would indicate a high ability of the hotel to pay short-term debts. However, an exceedingly high liquidity ratio is not a sign of astute liquidity management because overly high liquidity ratios signify sub-optimal use of funds. If these funds can be freed from current assets, greater investment in long-term assets can be made, which can be seen to represent the engine room from which the owners derive profits. To gain a better idea of which level of liquidity ratio is appropriate, you can use the average liquidity ratio for the hotel sector.

If a company experiences liquidity problems, a variety of options can be considered. For instance:

• Some fixed assets can be sold, maybe under a sale and lease-back agreement, for that will cause an increase in cash and have no effect on current liabilities.
• A long term loan could be an option, for that will increase the cash and have no effect on current liabilities.

[edit] 5.2.2 Financial leverage

Over the long term we are concerned with a company’s ability to pay all its debts, not only short-term debt. The long term indebtedness of the company is generally referred to as financial leverage or gearing. Thex financial leverage measures used most often are debt to assets and debt to equity ratios. They are calculated as follows:

Debt to assets = Total debt / Total assets

Debt to equity = Total debt / Total equity

Both ratios show us the level of debts of the company.

It is difficult to identify an optimal leverage ratio. However these ratios do provide a means for comparing a long-term liquidity position relative to that of its competitors. In addition, a trend analysis could highlight an alarming trend of increasing levels of indebtedness.

Lenders like to see a low level of financial leverage (low level of debt) as it signifies that there is a relatively low likelihood of insolvency resulting from an inability to cover debt obligation. Also owners should be concerned by the insolvency implications of high levels of debt because this means risk and high perceived risk will reduce the value of the hotel’s equity. Relative to many other industries, the hotel sector has a high business risk due to relatively volatile sales and a relatively high proportion of fixed costs. Therefore hotel managers should be wary of high levels of financial leverage. The greater the extent to which the business is financed by long-term borrowing which incurs fixed interest payments, the higher annual profit must be in order to cover this commitment.

On the other hand, a high level of debt can increase owners' returns, but only when trading conditions are favourable (this means the company can reach a high level of profitability). The reason for this is that once interest is covered, all remaining profit in shared among the relatively fewer holders of equity and the result is higher a return on equity. When the trading conditions are unfavourable and therefore a high risk for earning enough profit to cover the debt’s obligations exists, the managers should be more careful about the level of financial leverage or level of debt.

While the debt to assets and debt to equity ratio does not take into account an influence of the company’s profitability on the ability of the company to cover long-term debts, another ratio, named times interest earned or coverage ratio, is mostly used.

Times interest earned = EBIT / annual interest payment

This ratio shows us the extent to which interests charges are covered by the company’s level of profit. In other words, this ratio shows us the ability of the company to serve its debts. The higher this indicator is, the better the financial stability of the company is.

[edit] 6 Related topics/tools

• Ratio analysis
• P&L statement
• Balance sheet
• Cash flow statement
• Cash turnover ratio
• Liquidity management
• Working capital management

[edit] 7 links/sources

• Guilding, Chris (2005): Financial Management for Hospitality Decision Makers, First published 2002, Burlington.
• Owen, Gareth (1998): Accounting for Hospitality, Tourism & Leisure, 2.edition, Edinburgh.

LINK: from Key performance indicators – KPI’s