Financial Analysis data problem Assignement for smith_comp

Analyzing Financial Data

For the remainder of the lesson, you will be concentrating on learning some basic skills in financial calculations. It is important in finance to have an understanding of financial statements and how they are used to interpret the financial performance of corporations. We will review the various financial statements, and discuss how ratios are used to examine the different areas of a company’s financial operations. You will also learn about cash flow and the importance of managing the company’s cash operations to the overall financial planning.

Financial Statements and Analysis

In finance, it is key to have an understanding of financial statements from the perspective of being able to read them and knowing what goes where. Being able to compile them is, well, better left to the accountants. You will learn about that in another course! For our purposes, it will be enough for you to recognize the parts of each statement and be able to use them for analysis.

Four Key Financial Statements

Each corporation is required to file with the Securities and Exchange Commission (SEC) four key financial statements:

1. Income statement: provides a financial summary of the company’s operating results over a specified period of time.

2. Balance sheet: provides a summary statement of the company’s financial position at a given point in time.

3. Statement of Stockholders’ Equity: shows all the equity account transactions in a given year.

4. Statement of Cash Flows: summary of cash flows of a given period of time.

These financial statements are also used in order to do ratio analysis to examine the performance of a firm.

Using Financial Ratios

There are several reasons for doing ratio analysis. For example, if you are considering two investments between two companies, one that is a large company with a net income of $2 million in the previous year and the other a smaller startup with a net income of $200K; how do you decide which is the better investment?

It is not necessarily the larger company with the larger net income. There may be other factors that are not apparent without analysis of the financial status of each of the companies.

There are five general areas that you would want to explore. These are liquidity, activity, debt, profitability, and market ratios.

Liquidity Ratios

The first area to explore when beginning your analysis is the company’s liquidity. Liquidity is the company’s ability to pay its short-term bills. If a firm is having liquidity problems, it can be an indicator of cash flow problems that can signal larger internal difficulties. There are two primary measures of liquidity: the current ratio and the quick or acid-test ratio.

We will use the example of Pampered Pet’s balance sheet and income statement as we proceed through the following examples.

Current ratio	Current assets/Current liabilities	$72,000/$69,000 = 1.04
Quick ratio	Current assets-inventory/Current liabilities	$72,000-45,500/$69,000 =0.38

When looking at ratios, you should always take them as a comparison either with an industry benchmark or by doing a trend analysis over time. You would never want to look at a ratio as an isolated indicator. For the current ratio, the normal acceptable ratio is 2.0 and for the quick it is 1.0, but this can vary depending on the industry. By looking at our example, we can see that Pampered Pets does not have enough in assets to cover current liabilities by 2, in fact, it just barely has enough to cover its current liabilities. This could be a sign to worry. We will need to reserve judgment, however, until we complete our analysis.

Critical thought question: Why would the quick ratio be a truer measure of a firm’s ability to pay short term debts?

Activity Ratios

The second area of analysis is activity. Activity is a measure of how quickly the firm’s current assets are converted into cash. For example, inventory turnover is a measure of how quickly inventory is sold off or turned into cash. There are three other measures we will cover as well, and they are average collection period, and total asset turnover.

Inventory Turnover	COGS /Average Inventory	$106,000/ $45,500=2.33 (avg. already calculated)
Avg. Collection Period	Accts receivable/ (Annual sales/365)	$25,000/(160,000/365) =57.03 days
Total Asset Turnover	Sales/ Total Assets	$160,000/ $150,000=1.07

· Inventory turnover: measures the liquidity of the firm’s inventory. Useful only when compared to industry averages or past inventory turnovers

· Average collection period: useful when evaluating a firm’s credit policies

· Total asset turnover: indicates how efficiently the firm used its assets to generate sales during the year. The higher the better.

The inventory turnover for Pampered Pets could indicate a problem. The store may want to consider branching out into something less specialized such as fish that would generate more cash flow. The average collection period must be looked at in context with the collection policies of the store. If the credit policy for vendors is 30 days, then the company is not doing a good job of collecting receivables. However, if it is 60 days, then this ratio is fine. The total asset turnover indicates that the company is using its overall assets efficiently to generate sales.

Debt Ratios

The next area to consider is debt. You should be concerned with whether the firm is able to meet long-term financial obligations. There are two basic categories of debt measures. First, you want to know the degree to which the company is in debt with relation to other items on the balance sheet. Then you want to know about its ability to pay the interest on those debts.

Debt Ratio	Total liabilities/ Total assets	$91,950/ $150,000=61.3%
Times Interest Earned Ratio	EBIT/ Interest expense	$17,000/ 6,100=2.79

Although Pampered Pets is doing well to stay away from financing too much with debt, the loans they do have are generating quite a bit of interest. The earnings or profits before paying the interest expense on debt should, by rule of thumb, be three times the interest owed at a minimum. So, you can see here that Pampered Pets is not quite at that mark since its ratio is 2.79. They should consider raising more capital to expand operations into another product line that will increase profits and cash flow.

Profitability Ratios

The following ratios are used to measure how well management is utilizing company resources to earn a return on the funds invested by various groups.

Gross Profit Margin	(Sales-COGS)/ Sales	($160,000-106,000)/ $160,000 =33.76%
Operating Profit Margin	EBIT or Operating Income/Sales	$17,000/160,000=10.63%
Net Profit Margin	Net Income/Sales	$6,540/160,000=4.08%
Earnings per Share	Net Income/Shares Outstanding	$6,540/3,000=$2.18
Return on Total Assets	Net Income/ Total Assets	$6,540/150,000=4.36%
Return on Equity	Net Income/Shareholder Equity	$6,540/31,500=20.76%

Despite the liquidity problems identified earlier, which could be explained by a small business, Pampered Pets seems to be doing quite well from a profitability standpoint. For a small business owner, these ratios are indicative of stability. It seems that the company is supporting growth through equity instead of debt as well as indicated by the ROE ratio.

Market Ratios

The last area is the market ratios. This set measures how well the firm is doing in terms of the stock price and risk and return. The first ratio in this set is the Price/Earnings or PE Ratio. This ratio gives an idea of the owner’s opinion of the share value. This ratio indicates a degree of confidence from investors in the company. The other is the Market/Book or M/B Ratio which assesses investor’s perspective on a company’s performance.

Price Earnings Ratio	Market price per share common stock/ EPS	$25/$2.18 = 11.47
Market/Book Ratio	Market price per share common stock/ (Shareholder Equity/shares outstanding)	$25/($31,500/3000) =2.28

Generally speaking, Pampered Pets is in good shape. According to the PE Ratio, the company’s stock was selling for $25 per share and investors were paying $11.47 for every $1.00 of earnings. On the books, investors are paying $2.38 for each $1.00 of book value. This is a good indicator because investors are willing to pay more than book value for the stock, so the company is being viewed favorably by investors.

A Complete Ratio Analysis

So, what have we learned? The five measures of performance in a ratio analysis are liquidity, activity, debt, profitability, and market. Remember that just calculating any of these ratios on their own will do you no good, as we learned when we started off calculating the liquidity ratios on Pampered Pets. You must compare your findings with that of the industry and with previous calculations from previous years to get an idea of how the company is truly performing. Then, and only then, will you have done a complete ratio analysis.

Summary

This has been a lesson full of key concepts. You began by reviewing some accounting principles with a recap of the important financial statements and how they are used to perform ratio analysis for a company. You learned about the five areas of ratio analysis: liquidity, activity, debt, profitability, and market ratios. Each area tells us a little something about the performance of a company. We worked through the calculations of several different ratios in each category by looking at a company called Pampered Pets.

Balance Sheet

Sample Accounts

Cash Accounts Payable

Accounts Receivable Notes Payable

Inventories Accruals

Total Current Assets Total Current Liabilities

Land and Buildings Preferred Stock

Machinery & Equipment Common Stock

Vehicles Retained Earnings

Income Statement

Sample Accounts

Sales

COGS

Operating Expenses

Selling Expenses

Interest Expense

Earnings before Interest & Taxes (EBIT)

Net Income