Trend and Cross-Sectional Analysis - Building Block Approach and Common Size Income Statements - Example

Trend and Cross-Sectional Analysis Using the "Building Block Approach" and common size income ments and ments of cash flows Prof. Name November 01, 2011 Introduction In financial decision-making, individuals employ various approaches to information analysis. Ratio analysis forms one of the major tools used in analysis. Ratio analysis helps in measuring performance based on ratios of various financial statement variables. This research topic will enable increased understanding of financial ratios as tools of financial decision-making. In spite of the various challenges associated with the model, the model stands out as an easy to use and accurate model of financial analysis upon which financial decision-making is based. Ratio analysis is one of easiest measures for identifying salient features of the company. These ratios include profitability ratios, liquidity ratios, efficiency ratios and leverage ratios. Financial Analysis of a company is the critical look at financial performance of a company. Financial performance indicators used in analysis of the company include stock performance, financial ratios, dividend payout, competitors’ performance, and industry average measures, performance of market segments, interest coverage ratios, dividend yield, conclusions, and recommendation. Ratio Analysis Short-term solvency- Liquidity ratios are those, which come from the Balance sheet, which helps in knowing the liquidity of the particular company. This ratio is considered to be the important one in which its helps in knowing whether the company is able to match with its long term and short term obligations. ratio formula 2006 2005 2004 2003 2002 average Current ratio Current asset Current liabilities 1.61 1.61 1.66 1.62 1.55 1.61 Average collection period(days) Net accounts receivable Average daily sales 74.5 77.8 80.7 81.4 85.4 80.0 Days payable outstanding Accounts payable Average daily cost of sales 30.6 33.2 38.7 38.5 28.4 33.9 In the current ratio for the company remained constant for the period with slide fluctuations. Although having increased its current ratio, it is still considered that a minimum that company should have is a ratio of 2:1. However, as it stands with the company turning over a huge profit, the company does not have to worry about making payments for short-term liabilities as much as it would have if there were no confidence in the creditors about the profitability situation at the company. This figure helps an investor to know whether the company is in an apposition to pay dividends. These ratios are very important for the day to day smooth functioning of the firm; there have been examples of firms failing just because they did not have enough money to meet short-term needs although they were able to turn over a healthy margin. Average collection period appeared to be unstable but they were decreasing meaning that the management improved their crediting policy over the period. From the table above we can note that day’s payable outstanding were unstable but decreased by slide margin. These days are less to average collection period, meaning that the company has a negative cash conversion cycle. The rule is,” do not pay your creditors earlier than you are paid. Debt financing and coverage ratios- leverage ratios ratio formula 2006 2005 2004 2003 2002 average Debt ratio Total liability Total asset 0.57 0.62 0.52 0.6 0.64 0.59 Cash flow adequacy Cash flow from operating activities Capital(capital expenditure+ debt repayment+ dividend) 0.42 0.51 0.83 0.77 0.68 0.64 Long –term debt to total capitalization Long-term debt Long-term +equity 0.3 0.32 0.2 0.25 0.21 0,78 Financial leverage index ROCE ROA 0.51 0.2 1.33 1.58 1.48 1.02 Financial leverage ratio Total asset Total stockholders equity- preferred stock 2.3 2.6 2.095 2.47 2.8 2.46 2.02 2.16 2.48 2.18 1.93 2.15 The Bausch and Lomb’s Long-term solvency ratios present a very pleasing sight to the company’s shareholders. The total debt to total assets ratio of the firm shows that the firm has recently taken on some debt and retired some leaving it constant. This not a risky capital structure to have and Bausch and Lomb’s would be advised to focus on raising funds though mix of equity and debt to maintain these capital structure. The debt to total assets ratios demonstrates that Bausch and Lomb’s have enough Assets to cover for potential insolvency to cover its debt sufficiently. Cash flow adequacy is decreased meaning that the company has inability to generate cash from operations to finance payment of debt, purchase of capital equipment and payment of dividends is decreasing. This is quite discouraging to a dividend minded potential investor. Financial advantage index appears to have decreased to the point where the management should think of improving this ratio. It shows the return on assets is lower than the return on the equity at 2006 while it is big in 2002. This index shows how assets of the company are financed. Financial advantage ration shows how the assets of the company are covered by the equity. It appears that the assets of company coverage by equity remains stable a small standard deviation as the average is 2.46 and the largest amount is 2.8 with the smallest amount being 2.3. Credit scoring Z=3.3  +1.0  + .6 + 1.4  + 1.2  The firm’s Z score is above 2.15. This score is above the cutoff level for predicting bankruptcy, and thus would be considered favorable in terms of evaluating the firm’s creditworthiness. These assessments can streamline the credit decision and free up labor for other, less mechanical tasks. Utilization ratios ratio formula 2006 2005 2004 2003 2002 average Accounts receivable turn-over Net sales Net accounts receivable 4.9 4.7 4.5 4.5 4.3 4.6 Accounts payable turn-over Cost of goods sold Accounts payable 11.9 11.0 9.4 9.5 12.9 10.9 Gross profit margin (%) Gross profit Net sales 56.8 58.23 58.4 57.5 56.1 57.3 Operating profit margin Operating profit Net sales 5 12 12.5 11.7 8.2 9.9 Net profit margin Net earnings Net sales 0.65 0.82 6.89 6.26 3.99 3.72 According to David (37), efficiency ratios provide an indication of how well a company manage its resources, that is, how well a company employs its assets to generate sales and income. Further, it also shows the level of activity of the corporation as indicated by the turnover ratios. Commonly used ratios are accounts receivable turnover, accounts payable turnover, days payable among others. Computations of these ratios in context of Bausch and Lomb’s are shown in table above. From the table, there has been an improvement in the level of efficiency of the entity as indicated by a constant figure with a small standard deviation of accounts receivable turnover. On the contrary, accounts payable have decreased from 12.9 to 11.9 and have an average of 10.9. According to David (36), this ratio indicates how many sales how long the company takes to pay creditors. It measures the ability of a company’s assets to generate sales (David, 2003). From the table, four ratios are computed to illustrate profitability of Bausch and Lomb’, that is, gross profit margin, operating profit margin and net profit margin. Gross profit margin remained stable for the five years at 57.3 and a small standard deviation. This indicates that the company manages well its inventory, pricing and production efficiency. Net profit margin decreased from 3.99 to 0.65 %, which implies that the group generated inadequate sales revenue, which did not cover fixed costs and did not improved on profitability. This scenario can lower potential investors’ confidence on ability of the entity to generate returns from their capital. From this, it can be deduced that the entity has not been able to generate adequate sales from the investment to maintain the same level of profitability. Operating profit had the same trend as the net profit margin. Return on assets and return on equity ratio formula 2006 2005 2004 2003 2002 average ROA Net earnings Total assets 2.06 7.21 0.03 0.55 4.71 5.71 Return on equity Net earnings Stockholders equity 1.06 1.47 10.67 10.37 6.99 6.11 Return on assets and return on equity shows hoe the company is able to generate profits for the assets and the shareholders funds. The company appears to have unstable returns for these two sources of capital as the returns have fluctuated from year to year. The following graph shows a how these ratios have faired on. Market measures ratio formula 2006 2005 2004 2003 2002 average EPS Net earnings to equity No of shares 0.28 0.36 2.94 2.36 1.34 1.46 Price earnings ratio Market price Earnings per share 153.6 100 2.9 14 21.6 60.4 Value per share Total assets Number of shares 61.8 64.4 57 56.7 54.0 58.8 Investor ratios are the ratios principally designed to communicate to the investors the profitability of the company’s stock as an investment. Earnings per share indicate the return to common stock shareholder for each share that the investor owns. Dividend yield shows the rate earned by shareholders from dividend relative to the stock price, while price to earnings ratio expresses the multiple that the market attributes to a common stock relative to its price the following table shows the different formulae used in the computation of the aforementioned investor ratios. A high price-to-earnings ratio suggests that the investors of the organization are expecting a higher earnings growth on the stocks they hold in the future. This ratio is typically a measure of expected growth and not necessarily, the growth realized on the stocks of the organization. The ratios of both the organization that are being examined for the study are relatively low in comparison with the industry figure. This means, that the growth potential and expectations are not very high like other industries. It is pertinent to note that, Price-to-earnings ratio may not explain the entire required information. David (23) states that price/earnings ratio is the most commonly used to evaluate investment in an entity. He further points out that historically, the average P/E ratio for the broad market has been around 15, although it can fluctuate significantly depending on economic and market conditions. A stock with a high price/earnings ratio suggests that investors are expecting higher earnings growth in the future compared to the overall market while a stock with a low price/earnings ratio suggests that investors have more modest expectation for its future growth compared to the market as a whole (David, 78). From the computations of price/earnings ratio for Bausch and Lomb in table above, the ratio increased from 21.6 to 153.6. This increase may be attractive to prospective growth investors despite the increase in earnings per share and dividends. Value per share increased slightly from 54.0 to 61.8 over the period. This means that every potential shareholder share for assets increased over the period this is a positive change meaning that the company is not very risk. Common size The comparative study which is either from balance sheet or from the income statement for multiple accounting period in order to compute both relative and total variance for every single item found in the balance sheet and income statement. In this the balance sheet and income statement of the Bausch and Lomb’ is presented and calculated on the bases of “consecutive years.” In the balance sheet while looking into the assets it shows that Bausch and Lomb’ has a good cash level with a higher percentage from 2002-2006. When looking into the accounts receivable it shows that it is reducing from 2002-2006 which means that it collects the payment at a faster rate .This is showing that the credit policies are being made in the better way when comparing with the Bausch and Lomb’ to the industry norm. The inventory of Bausch and Lomb’ is declining which means that it faces an improper sales and the cost of production is being controlled to a higher level. The total current asset of the Bausch and Lomb’ is declining slowly but with the help of the current ratio it was able to maintain a steady flow from 2002-2006 which is a good advantage for the Bausch and Lomb’. The fixed asset of s.ing the firm is low which is due to the depreciation value on the fixed assets. When looking into the liabilities of the Bausch and Lomb’, the accounts receivable is less which means that the firm does not owe to anyone and it has very less borrowings also which is very good for the firm. With the steady current ratio of the firm, it was also able to borrow short-term loan from the banks, which showed that the bank had the trust with the firm, and eventually the firm was able to pay back at the right time, which was mentioned by the bank. This also can be considered as the other reason for the current assets being higher than the current liabilities. In the income statement, it is looked on the Net Income, EBIT, Gross profit, and Sales of the firm. The gross profit of the firm is reducing from 2002-2006 which can be caused due to the cost of production and it is very bad for the firm. The firm should start implementing the method of cost controlling which means that by reducing the wages and other overheads so that it can be help the firm in a much better way. For the Bausch and Lomb’ cutting down the cost is very important for their better survival in the market. Even when it comes to the administration expenses and other expenses there was not any increase or decrease. The Net income reduced very much by the year 2005, which is mainly due to the recession. Conclusion A shareholder interested in profits should not buy this shares, however if he has the shares he should hold it. The other investors who are interested in capital gains should buy the share or hold it if they have it. Works Cited Bruner, Robert. Case Studies in Finance: Managing for Corporate Value Creation. New York: Irwin McGraw-Hill, 1998. Print. David, Vance. Financial analysis and decision making: Tools and techniques to solve. United States: McGraw-Hill books, 2003. Print. Eugene, Brigham, and Michael, Ehrhardt. Financial management theory and practice. London: Cambridge, 2009. Print. Graham, Benjamin. Securities Analysis. New York: McGraw Hill, 2004. Print. Graham, Benjamin. 2006. The Intelligent investor. New York: McGraw Hill, 2006. Print. Krackov, Lawrence and Kaushik, Surendra. “The Practical Financial Manager”, New York: New York Institute of Finance, 1998. Print. Revsine. Financial Analysis and Reporting. New York: Pearson Hall, 2004. Print. Read More