LECTURE 2

PERFORMANCE ANALYSIS
(Tools for Financial Analysis and Control)
 Responsibilities of the Financial Manager

1. Managing the
working capital 2. Estimating the
seasonal fund needs

3. Long-term financial
planning: forecasting long-
term fund requirements

4. Determining appropriate
investment mix
6. Determining the
amount of dividends 5. Determining appropriate
to be paid financing mix
2
 Inter-relationships between financing,
investment and dividend decisions
Investment: Finance: Company Dividends: if finance is
Company decides to will need to raise not available from
take on a large finance in order to external sources,
number of attracting take on projects dividends may need to be
new investment cut in order to increase
projects internal financing
Dividends: company Finance: lower level Investment: if finance is
decides to pay higher of retained earnings not available from
levels of dividends to available for external sources the
shareholders investment means company may have to
company may have to postpone future
find finance from investment projects
external sources
Finance: company Investment: due to Dividends: the
finances itself using a higher cost of company’s ability to pay
more expensive capital the number of dividends in the future
sources resulting in a projects attractive to will be adversely affected
higher cost of capital the company
decreases
 Learning Activity
• What are the basic financial statements that
should be prepared by a business firm?
• What are the uses of each of the basic
financial statements?
 Basic Financial Statements

• The Income Statement

• The Balance Sheet
• The Statement of Retained Earnings
• The Statement of Cash Flows
 Learning Activity
• What is financial statement analysis and why
is it important?
 Financial Statement Analysis
• What is financial statement analysis?
”Tearing apart” the financial statements and
looking at the relationships
• Financial statements summarize and provide an
overview of events relating to the functioning of a
firm.
• Financial statement analysis helps identify
– a firm’s strengths and
– weaknesses
– so that management can take advantage of a firm’s
strengths and make plans to counter weaknesses of the
firm.
• The strengths must be understood if they are to be used to
proper advantage and weaknesses must be recognized if
corrective action needs to be taken
 Significance of Financial Statements Analysis
• For example:
– Are inventories adequate to support the projected level of
sales?
– Does the firm have too heavy an investment in account
receivable?
– Does large account receivable reflect a lax collection
policy?
– To ensure efficient operations of a firm’s manufacturing
facility, does the firm have too much or too little invested
in plant and equipment?
• Financial statement analysis provides answers to all
of these questions.
Who Analyses Financial Statements?
• Who analyzes financial statements?
– Internal users (i.e., management)
– External users (emphasis of lecture)
• Examples?
– Investors, creditors, regulatory agencies & …
– Financial analysts
– Auditors
– Researchers
– etc
 A Firm’s Stakeholders
A company has responsibility to different interested parties

Government
Creditors

Employees Customers

The firm

Managers Society

Shareholders
 Financial Statement Analysis
• What do internal users use it for?
Planning, evaluating and controlling company
operations
• What do external users use it for?
Assessing past performance and current financial
position and making predictions about the future
profitability and solvency of the company as well
as evaluating the effectiveness of management
 Financial Statement Analysis
Information is available from
– Published annual reports
(1) Financial statements
(2) Notes to financial statements
(3) Letters to stockholders
(4) Auditor’s report (Independent accountants)
(5) Management’s discussion and analysis
 Financial Statement Analysis
Information is available from (Cont…)
– Other sources
(1) Newspapers (e.g., Business Times, Financial Times )
(2) Periodicals (e.g. Forbes, Fortune)
(3) Financial information organizations such as:
Moody’s, Standard & Poor’s, Dun & Bradstreet, Inc.,
and Robert Morris Associates
(4) Other business publications
 Methods of
Financial Statement Analysis
• Horizontal Analysis
• Vertical Analysis
• Common-Size Statements
• Trend Percentages
• Ratio Analysis
 Horizontal Analysis

Using
Using comparative
comparative financial
financial statements
statements to to
calculate
calculate monetary
monetary (Tshs)
(Tshs) or
or percentage
percentage
changes
changes inin aa financial
financial statement
statement item
item from
from
one
one period
period toto the
the next
next
 Vertical Analysis
For
For aa single
single financial
financial statement,
statement,
each
each item
item isis expressed
expressed as as aa
percentage
percentage of of aa significant
significant total,
total,
e.g.,
e.g., all
all income
income statement
statement items
items are
are
expressed
expressed as as aa percentage
percentage of of sales
sales
and
and all
all balance
balance sheet
sheet items
items areare
expressed
expressed as as aa percentage
percentage of of total
total
assets
assets
Common-Size Statements
Financial
Financial statements
statements that
that show
show
only
only percentages
percentages and
and nono
absolute
absolute monetary
monetary amounts
amounts
 Trend Percentages
Show
Show changes
changes over
over time
time in
in
given
given financial
financial statement
statement items
items
(can
(can help
help evaluate
evaluate financial
financial
information
information of
of several
several years)
years)
 Ratio Analysis
Expression
Expression of
of logical
logical relationships
relationships
between
between items
items inin aa financial
financial statement
statement of
of aa
single
single period
period (e.g.,
(e.g., percentage
percentage relationship
relationship
between
between revenue
revenue and and net
net income)
income)
 Horizontal Analysis Example

Assume that the management of UD Co Ltd

provides you with comparative balance sheets
of the years ended December 31, 2014 and
2013. Management asks you to prepare a
horizontal analysis on the information.
 UD Company
Comparative Balance Sheet,
31 December,2013 and 2012
2013 2012 Increase (Decrease)
Amount %
Assets
Current Assets
Cash 12,000 23,500
Accounts Receivable, Net 60,000 40,000
Inventory 80,000 100,000
Prepaid Expenses 3,000 1,200
Total Current Assets 155,000 164,700
Property and Equipment
Land 40,000 40,000
Building & Equipment, Net 120,000 85,000
Total Land & Equipment 160,000 125,000
Total Assets 315,000 289,700
 Horizontal Analysis Example
Calculating Change in Tshs Amounts

Tshs = Current Year – Base Year

Change Figure Figure
 Horizontal Analysis Example
Calculating Change in Monetary Amounts

Tshs = Current Year – Base Year

Change Figure Figure

Since we are measuring the amount of the change

between 2012 and 2013, the Tshs amounts for
2012 become the “base” year figures.
 Horizontal Analysis Example
Calculating Change as a Percentage

Percentage Tshs Change

= × 100%
Change Base Year Figure
Horizontal Analysis Example

$12,000 – $23,500 = $(11,500)

Horizontal Analysis Example

($11,500 ÷ $23,500) × 100% = 48.9%

Horizontal Analysis Example
 Horizontal Analysis Example
• Let’s apply the same procedures to the
liability and stockholders’ equity sections of
the balance sheet.

28
 UD Co Ltd
Comparative Balance Sheets
December 31, 2014 and 2013
Increase
(Decrease)
2014 2013 Amount %
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable $ 67,000 $ 44,000 $ 23,000 52.3
Notes payable 3,000 6,000 (3,000) (50.0)
Total current liabilities 70,000 50,000 20,000 40.0
Long-term liabilities:
Bonds payable, 8% 75,000 80,000 (5,000) (6.3)
Total liabilities 145,000 130,000 15,000 11.5
Stockholders' equity:
Preferred stock 20,000 20,000 - 0.0
Common stock 60,000 60,000 - 0.0
Additional paid-in capital 10,000 10,000 - 0.0
Total paid-in capital 90,000 90,000 - 0.0
Retained earnings 80,000 69,700 10,300 14.8
Total stockholders' equity 170,000 159,700 10,300 6.4
Total liabilities and stockholders' equity $ 315,000 $ 289,700 $ 25,300 8.7
 Horizontal Analysis Example
• Now, let’s apply the procedures to the
income statement

30
 UD Co Ltd
Comparative Income Statements
For the Years Ended December 31, 2014 and 2013
Increase (Decrease)
2014 2013 Amount %
Net sales $ 520,000 $ 480,000 $ 40,000 8.3
Cost of goods sold 360,000 315,000 45,000 14.3
Gross margin 160,000 165,000 (5,000) (3.0)
Operating expenses 128,600 126,000 2,600 2.1
Net operating income 31,400 39,000 (7,600) (19.5)
Interest expense 6,400 7,000 (600) (8.6)
Net income before taxes 25,000 32,000 (7,000) (21.9)
Less income taxes (30%) 7,500 9,600 (2,100) (21.9)
Net income $ 17,500 $ 22,400 $ (4,900) (21.9)
 UD Co Ltd
Comparative Income Statements
For the Years Ended December 31, 2014 and 2013
Increase (Decrease)
2014 2013 Amount %
Net sales $ 520,000 $ 480,000 $ 40,000 8.3
Cost of goods sold 360,000 315,000 45,000 14.3
Gross margin 160,000 165,000 (5,000) (3.0)
Operating expenses 128,600 126,000 2,600 2.1
Net operating income 31,400 39,000 (7,600) (19.5)
Interest expense 6,400 7,000 (600) (8.6)
Net income before taxes 25,000 32,000 (7,000) (21.9)
Less income taxes (30%) 7,500 9,600 (2,100) (21.9)
Net income $ 17,500 $ 22,400 $ (4,900) (21.9)

Sales increased by 8.3% while net income

decreased by 21.9%.
 UD Co Ltd
Comparative Income Statements
For the Years Ended December 31, 2013 and 2013
Increase (Decrease)
2014 2013 Amount %
Net sales $ 520,000 $ 480,000 $ 40,000 8.3
Cost of goods sold 360,000 315,000 45,000 14.3
Gross margin 160,000 165,000 (5,000) (3.0)
Operating expenses 128,600 126,000 2,600 2.1
Net operating income 31,400 39,000 (7,600) (19.5)
Interest expense 6,400 7,000 (600) (8.6)
Net income before taxes 25,000 32,000 (7,000) (21.9)
Less income taxes (30%) 7,500 9,600 (2,100) (21.9)
Net income $ 17,500 $ 22,400 $ (4,900) (21.9)

There were increases in both cost of goods sold (14.3%) and

operating expenses (2.1%). These increased costs more than
offset the increase in sales, yielding an overall decrease in net
income (21.9%).
 Vertical Analysis Example
Assume that the management of BS Company
Ltd asks you to prepare a vertical analysis for
the comparative balance sheets of the
company.
Vertical Analysis Example
 Vertical Analysis Example

$82,000 ÷ $483,000 = 17% rounded

$30,000 ÷ $387,000 = 8% rounded
 Vertical Analysis Example

$76,000 ÷ $483,000 = 16% rounded

 Trend Percentages Example
Assume that MD Co Ltd provides you with the
following operating data and asks that you
prepare a trend analysis.
 Trend Percentages Example
Assume that MD Co Ltd provides you with the
following operating data and asks that you
prepare a trend analysis.

$1,991 - $1,820 = $171

 Trend Percentages Example
Using 2010 as the base year, we develop the
following percentage relationships.

$1,991 - $1,820 = $171

$171 ÷ $1,820 = 9% rounded
 RATIO ANALYSIS
• Financial statements report both on a firm’s position
at a point in time and on its operations over some
past period.
• From management’s viewpoint, financial statement
analysis is useful both as a way to
– anticipate future conditions and
– more important, as a starting point for planning
actions
– that will influence the future course of events or
– to show whether a firm’s position has been
improving or deteriorating over time.
 Ratio Analysis (Cont…)
• Ratio analysis begins:
– with the calculation of a set of financial ratios
– designed to show the relative strengths and
– weaknesses of a company as compared to
• Other firms in the industry
• Leadings firms in the industry
• The previous year of the same firm
• Ratio analysis helps to show whether the firm’s
position has been improving or deteriorating
• Ratio analysis can also help plan for the future
 Ratios
Ratios can be expressed in three different
ways:
1. Ratio (e.g., current ratio of 2:1)
2. % (e.g., profit margin of 2%)
3. $ (e.g., EPS of Tshs 225)

CAUTION!
“Using ratios and percentages without
considering the underlying causes may
lead to incorrect conclusions.”
 Major Categories of Ratios
• Liquidity Ratios
Indicate a company’s short-term debt-paying ability
• Asset Management
Measure how effectively the firm is managing/using its
assets
• Equity (Long-Term Solvency) Ratios
Show relationship between debt and equity financing
in a company
• Profitability Tests
Relate income to other variables
• Market Tests
Help assess relative merits of stocks in the market
place
 The 10 Basic Ratios you have to know
• Liquidity Ratios
1. Current Ratio (Working Capital Ratio)
2. Quick Ratio/Acid Test Ratio
Cash Ratio/Cash Flow liquidity Ratio
• Asset Management Ratios
3. Inventory Turnover Ratio
4. Days Sales Outstanding
5. Inventory Turnover Ratio
Fixed Assets Turnover Ratio
Total Assets Turnover Ratio
• Equity (Long-term solvency/Debt Management Ratios
6. Equity (stockholders’ equity) ratio - Equity to debt
Total Debt to Total Assets Ratio
Times Interest Covered Ratio
 The 10 Basic Ratios you have to know
• Profitability Ratios
7. Profit Margin - Net income to net sales (return on sales)
8. Earnings per share
9. Return on average common stockholders’ equity ( ROE)
ROE
• Return on Assets
• Return on Equity
• Basic Earning Power Ratio
• Cash flow margin
• Times interest earned
• Times preferred dividends earned
 The 10 Basic Ratios you have to know
• Market Tests
10. Price-earnings ratio
• Earnings yield on common stock
• Payout ratio on common stock
• Dividend yield on common stock
• Dividend yield on preferred stock
• Cash flow per share of common stock
Ratio Analysis - Example
 Ratio Analysis - Example
• Calculate the 10 basic ratios based on Neema
Co Ltd’s financial statements
 Neema Co Ltd
2014
Cash $ 30,000
Accounts receivable, net
Beginning of year 17,000
We will
End of year 20,000
use this
Inventory
information
Beginning of year 10,000
to calculate
End of year 12,000
the liquidity
Total current assets 65,000
ratios for
Total current liabilities 42,000
Neema Co Ltd.
Sales on account 494,000
Cost of goods sold 140,000
 Working Capital*
The excess of current assets over current liabilities.

12/31/14
Current assets $ 65,000
Current liabilities (42,000)
Working capital $ 23,000

* While this is not a ratio, it does give an

indication of a company’s liquidity.
Current (Working Capital) Ratio
#1
Current = Current Assets
Ratio Current Liabilities
Current = $65,000 = 1.55 : 1
Ratio $42,000

Measures the ability of the company to

pay current debts as they become due.
 Acid-Test (Quick) Ratio
#2

Acid-Test Ratio = Quick Assets

Current Liabilities

Quick assets are Cash, Marketable Securities,

Accounts Receivable (net) and current Notes
Receivable.
 Acid-Test (Quick) Ratio
#2

Acid-Test Quick Assets

=
Ratio Current Liabilities

Neema Co Ltd’s quick assets consist of cash of

$30,000 and accounts receivable of $20,000.
 Acid-Test (Quick) Ratio
#2
Quick Assets
Acid-Test Ratio =
Current Liabilities

Acid-Test Ratio $50,000 1.19 : 1

= =
$42,000
 Accounts Receivable Turnover
Net, credit sales #3 Average, net accounts
receivable
Accounts
Sales on Account
Receivable =
Average Accounts Receivable
Turnover
Accounts
$494,000
Receivable = = 26.70 times
($17,000 + $20,000) ÷ 2
Turnover

This ratio measures how many

times a company converts its
receivables into cash each year.
 Number of Days’ Sales
in Accounts Receivable
#4
Days’ Sales
= 365 Days
in Accounts
Accounts Receivable Turnover
Receivables
Days’ Sales
365 Days
in Accounts = = 13.67 days
26.70 Times
Receivables

Measures, on average, how many days

it takes to collect an account receivable.
 Number of Days’ Sales
in Accounts Receivable
#4
Days’ Sales
= 365 Days
in Accounts
Accounts Receivable Turnover
Receivables
Days’ Sales
365 Days
in Accounts = = 13.67 days
26.70 Times
Receivables

In practice, would 45 days be a desirable

number of days in receivables?
 Inventory Turnover
#5
Inventory Cost of Goods Sold
=
Turnover Average Inventory

Inventory $140,000
= = 12.73 times
Turnover ($10,000 + $12,000) ÷ 2

Measures the number of times inventory is

sold and replaced during the year.
 Inventory Turnover
#5
Inventory Cost of Goods Sold
=
Turnover Average Inventory

Inventory $140,000
= = 12.73 times
Turnover ($10,000 + $12,000) ÷ 2

Would 5 be a desirable number of times

for inventory to turnover?
 Equity, or Long–Term
Solvency Ratios
This is part of the information to calculate the
equity, or long-term solvency ratios of Norton
Corporation.
Neema Co Ltd
2014
Net operating income $ 84,000
Net sales 494,000
Interest expense 7,300
Total stockholders' equity 234,390
 Neema Co Ltd
2014
Common shares outstanding
Beginning of year 17,000
End of year 27,400
Net income $ 53,690
Here is the Stockholders' equity
rest of the Beginning of year 180,000
information
End of year 234,390
we will
Dividends per share 2
use.
Dec. 31 market price/share 20
Interest expense 7,300
Total assets
Beginning of year 300,000
End of year 346,390
 Equity Ratio
#6
Equity Stockholders’ Equity
=
Ratio Total Assets

Equity $234,390
= = 67.7%
Ratio $346,390

Measures the proportion of total assets provided by

stockholders.
 Net Income to Net Sales
A.K.A. Return on Sales or Profit Margin
#7
Net Income
= Net Income
To Net Sales
Net Sales

Net Income
$53,690
To Net Sales = = 10.9%
$494,000

Measures the proportion of the sales (Tshs)

which is retained as profit.
 Net Income to Net Sales
A.K.A. Return on Sales or Profit Margin
#7
Net Income
= Net Income
To Net Sales
Net Sales

Net Income
= $53,690
To Net Sales = 10.9%
$494,000

Would a 1% return on sales be good?

 Return on Average Common
Stockholders’ Equity (ROE)
#8

Return on Net Income

Stockholders’ = Average Common
Equity Stockholders’ Equity

Return on
$53,690
Stockholders’ = = 25.9%
($180,000 + $234,390) ÷ 2
Equity

Important measure of the income-producing ability

of a company.
 Earnings Per Share
#9
Earnings Available to Common Stockholders
Earnings = Weighted-Average Number of Common Shares
per Share
Outstanding

Earnings $53,690
= = $2.42
per Share (17,000 + 27,400) ÷ 2

The financial press regularly publishes

actual and forecasted EPS amounts.
 Price-Earnings Ratio
A.K.A. P/E Multiple
#10

Price-Earnings = Market Price Per Share

Ratio EPS
Price-Earnings $20.00
= = 8.3 : 1
Ratio $ 2.42

Provides some measure of whether the

stock is under or overpriced.
 The DuPont System
• Developed in 1919 by a finance executive at
E.I. du Pont de Nemours and Co
• A way of visualizing the information so that
everyone can see it
• Is a good tool for getting people started in
understanding how they can have an impact
on results
• It is a simple and straightforward method for
assessing the factors that influence a firm’s
financial performance
72
 The DuPont System
• Method to breakdown ROE into:
– ROA and Equity Multiplier
• ROA is further broken down as:
– Profit Margin (profitability)
– Asset Turnover (efficiency in using the assets)
• Helps to identify sources of strength and
weakness in current performance
• Helps to focus attention on value drivers
73
 DuPont Chart and Equation
• DuPont Chart and Equation - Tie the Ratios
Together
– Shows how profit margin, asset turnover ratio,
and equity multiplier determine ROE
– Shows how expense control (profit margin),
efficient use of assets in production (asset
turnover) and capital structure (equity multiplier)
affect return on equity.
– Ties together all aspects of firm - production and
financing.
 Return on Equity - ROE
• This represents the Net income generated by
the Equity invested in the business
• The Formula is:

Net Income
Equity
– This represents amount of profit per Tshs invested
by the shareholders.

75
 DuPont System – What is It?
• The system identifies profitability as being impacted by
three different levers:
– Earnings & efficiency in earnings Earnings
– Ability of your assets to be turned into profits Efficiency

– Financial leverage Leverage

• DuPont analysis tells us that ROE is affected by three
things:
– Operating efficiency, which is measured by profit margin.
– Asset use efficiency, which is measured by total asset
turnover.
– Financial leverage is measured by the equity multiplier

76
 Net Total
ROE Profit Asset Debt
Margin Turnover Ratio
Net Income Net Income Sales Total Assets
= X X
Total Equity Sales Total Assets Total Equity

Asset Usage
Profitability Efficiency Leverage

77
78
 The DuPont System
ROE

ROA E q u ity M u ltip lie r

P ro fit M a rg in T o ta l A s s e t T u rn o v e r

79
 The DuPont System
ROE

ROA E q u ity M u ltip lie r

P ro fit M a rg in T o ta l A s s e t T u rn o v e r

Notice that using more debt (and less equity) to finance assets
raises the Equity Multiplier. This has two effects for stockholders.

The Equity Multiplier acts as a lever to magnify the effects of ROA

on returns for stockholders. If ROA is positive, ROE is a larger
positive value, but if ROA is negative ROE is a larger negative.
80
 The DuPont System
ROE

ROA E q u ity M u ltip lie r

P ro fit M a rg in T o ta l A s s e t T u rn o v e r
Return on Assets is affected by two areas of operations. The Profit Margin
measures the degree to which the firm controls expenses. Since expenses comprise
the difference between Sales and Net Income, lowering the expenses taken out of
each shilling of sales raises the Profit Margin.

At the same time, Return on Assets can be raised by producing sales by using fewer
assets. Asset Turnover measures the sales produced with each shilling invested in
assets. This is often thought of as sales volume.

Different industries achieve ROA in different ways. Some have low profit margins
but high volume, e.g. grocery stores. Others have lower volume but are able to
maintain higher profit margins, e.g. car dealerships. 81
 The DuPont System
ROE

ROA E q u ity M u ltip lie r

P ro fit M a rg in T o ta l A s s e t T u rn o v e r

82
 DuPont Equation

ROE = Profit Margin × Total Asset Turnover × Equity Multiplier

Net Income Sales Total Assets
= × ×
Sales Total Assets Common Equity

83
 DuPont System
Earnings/Profitability
Operating
Profit Margin
Return On
Income X = Assets (less
Stream interest adj.)
Asset
Turnover Return On
X =
Equity
Asset Efficiency Usage

Financial
Investment
Structure
Stream
Leverage
84
 DuPont System Ratios
Profitability
Operating
Profit Margin
Return On
Income X = Assets (less
Stream interest adj.)
Asset
Turnover Return On
X =
Equity
Efficiency

Financial
Investment
Structure
Stream
Leverage
85
 Problems in Financial Statement and
Ratio Analysis
• Developing and Using Comparative Data
• Distortion of Comparative Data
• Notes to Financial Statements
• Interpretation of Results
• Differences in Accounting Treatment
• Window Dressing
• Effects of Inflation
 Important Considerations
• Need for comparable data
– Data is provided by companies such as Dun &
Bradstreet, Standard & Poor’s etc.
– Must compare by industry
– Is EPS comparable?

• Influence of external factors

– General business conditions
– Seasonal nature of business operations
• Impact of inflation