Financial Statement Analysis

Gestão Financeira I
Gestão Financeira
Corporate Finance I
Corporate Finance

Licenciatura/ Undergraduate Program

2022-2023
 Outline

1. Firms’ Disclosure of Financial Information

2. The Balance Sheet
3. The Income Statement
4. The Statement of Cash Flows
5. Other Financial Statement Information
6. Financial Statement Analysis

GFI / GF /CF1/CF 2022-2023

2
Firms’ Disclosure of Financial Information

• Financial statements are accounting reports issued

periodically to present past performance and a
snapshot of the firm’s assets and the financing of those
assets
• Investors, financial analysts, managers, and other
interested parties such as creditors rely on financial
statements to obtain reliable information about a
corporation
• Public companies must file financial results with the
relevant listing authorities
• The annual report with financial statements must be
sent to their shareholders every year

GFI / GF /CF1/CF 2022-2023

3
 The Balance Sheet
• Also called “Statement of Financial Position”
• Lists the firm’s assets and liabilities
• Provides a snapshot of the firm’s financial position at a given
point in time
• The Balance Sheet Equation
– The two sides of the balance sheet must balance

Assets = Liabilities + Shareholders’ Equity

GFI / GF /CF1/CF 2022-2023

4
 The Balance Sheet:Global Conglomerate
Corporation Balance Sheet for 2016 and 2015

GFI / GF /CF1/CF 2022-2023

5
 The Balance Sheet
• Net Working Capital:
The capital that will be available in the short term to run the business.

• Not all this working capital is cash (net of paying short term debt).
From a managerial perspective, and in terms of financial planning,
this might mean that the company needs to get extra funds to
finance its operating activity. This difference might be called:
• Working Capital Requirements = Net Working Capital – Net Cash =
= Net Working Capital – (Cash & Marketable Securities – Short-Term Debt)

GFI / GF /CF1/CF 2022-2023

6
 The Balance Sheet

• Shareholders’ Equity
– Market Value Versus Book Value
• Book value of equity
– An accounting measure of net worth
– Assets – Liabilities = Equity
– True value of assets may be different from book value
• Market capitalization
– Market price per share times number of shares
– Does not depend on historical cost of assets

GFI / GF /CF1/CF 2022-2023

7
 Market versus Book Value
Problem:
• If Global had 3.6 million shares outstanding, and these shares
are trading for a price of $10 per share, what is Global’s’s
market capitalization?
• Global’s market capitalization is:
(3.6m shares)  ($10/share) = $36 million

• How does the market capitalization compare to Global’s book

value of equity?
• This market capitalization is significantly higher than Global’s book value
of equity (slide 5):
$22.2 million
– Investors are willing to pay 36/22.2 = 1.62 times the amount Global’s
shares are “worth” according to their book value.

GFI / GF /CF1/CF 2022-2023

8
 The Balance Sheet

• Market to Book Ratio

– The ratio of a firm’s market capitalization to the
book value of shareholders’ equity:

Market Value of Equity

Market-to-Book Ratio =
Book Value of Equity

– Also called Price-to-Book ratio

– Sometimes used to classify firms as value (low
M/B) or growth (high M/B)
GFI / GF /CF1/CF 2022-2023
9
Market-to-Book Ratios in 2016

GFI / GF /CF1/CF 2022-2023

10
 The Balance Sheet

• Enterprise Value
– The value of the underlying business
assets, unencumbered by debt and
separate from any cash and marketable
securities
Enterprise Value = Market Value of Equity + Debt - Cash
– Note 1 In a way this would represent the total market
value of all operating assets: fixed and intangible assets
(non-current)+net working capital, except for cash and
its equivalents

GFI / GF /CF1/CF 2022-2023

11
Problem:
• In June 2013, H.J. Heinz Co. (HNZ) had a share price of $72.36, a market-to-
book ratio of 7.66, a book value of debt of $4,984 million, and cash of
$1,100.7 million
• What was Heinz’s market capitalization (its market value of equity)?
Share Price:$72.36
Shares outstanding: 320.7 million
Cash: $1.10 billion
Debt (book): $4.98 billion

• Heinz had market capitalization of $72.36  320.7 million shares

= $23.21 billion
• What was its enterprise value?
• Thus, Heinz’s enterprise value was
23.21+ 4.98 – 1.1 = $27.09 billion
GFI / GF /CF1/CF 2022-2023
12
 The Income Statement
• The income statement lists the firm’s
revenues and expenses over a period of time
– Sometimes called the profit and loss statement, or
“P&L”
• The last or “bottom” line of the income
statement shows net income
– A measure of its profitability during the period
– Also referred to as the firm’s earnings

GFI / GF /CF1/CF 2022-2023

13
 The Income Statement: Global Conglomerate
Corporation Balance Sheet for 2016 and 2015

CMVMC
Margem Bruta de Vendas

Resultado Líquido

GFI / GF /CF1/CF 2022-2023

14
 The Income Statement

• Earnings Per Share

– Net income reported on a per-share basis
Net Income
EPS =
Number of Shares Outstanding

– Fully diluted EPS increases number of shares by:

• Stock options issued to employees
– The right to buy a certain number of shares by a specific date at a specific
price
• Shares issued due to conversion of convertible bonds
– Convertible bonds are corporate bonds with a provision that gives the
bondholder an option to convert each bond into a fixed number of shares
of common stock

GFI / GF /CF1/CF 2022-2023

15
 The Income Statement

• EBITDA
– Financial analysts often compute a firm’s earnings
before interest, taxes, depreciation, and
amortization, or EBITDA
– Because depreciation and amortization are not
cash flows, this subtotal reflects the cash a firm
has earned from operations

GFI / GF /CF1/CF 2022-2023

16
 The Statement of Cash Flows

• The firm’s statement of cash flows uses the

information from the income statement and
balance sheet to determine:
– How much cash the firm has generated
– How that cash has been allocated during a set
period
• Cash is important because it is needed to pay
bills and maintain operations and is the source
of any return of investment for investors

GFI / GF /CF1/CF 2022-2023

17
The Statement of Cash Flows: Global Conglomerate
Corporation Balance Sheet for 2016 and 2015

GFI / GF /CF1/CF 2022-2023

18
 The Statement of Cash Flows

• Financing Activity
– Payout Ratio and Retained Earnings

Retained Earnings = Net Income – Dividends

GFI / GF /CF1/CF 2022-2023

19
 Financial Statement Analysis

• Investors often use accounting statements to:

– Compare the firm with itself by analyzing how the
firm has changed over time
– Compare the firm to other similar firms using a
common set of financial ratios

GFI / GF /CF1/CF 2022-2023

20
 Financial Statement Analysis
• Profitability Ratios
– Gross Margin – Net Profit Margin
• How much a company • The fraction of each
earns from each dollar dollar in revenues that
of sales after paying is available to equity
for the items sold holders after the firm
pays interest and
Gross Profit taxes
Gross Margin =
Sales Net Income
Net Profit Margin =
– Operating Margin Sales
• How much a company
– EBIT Margin
earns before interest
EBIT
and taxes from each EBIT Margin =
Sales
dollar of sales
Operating Income
Operating Margin =
Sales

GFI / GF /CF1/CF 2022-2023 21

 Financial Statement Analysis
• Liquidity Ratios
– Current Ratio
• The ratio of current assets to current liabilities
Current Assets
Current Ratio =
Current Liabilities

– Quick Ratio
• The ratio of current assets other than inventory to current liabilities,
because inventory is not as liquid as all other current assets
Current Assets - Inventory
Quick Ratio =
Current Liabilities
– Cash Ratio
• The most stringent liquidity ratio: Cash Ratio = Cash
Current Liabilities
GFI / GF /CF1/CF 2022-2023
22
 Financial Statement Analysis
• Asset Efficiency
– Asset Turnover
• A first broad measure of efficiency is asset turnover

Sales
Asset Turnover =
Total Assets

– Fixed Asset Turnover

• Since total assets include assets that are not directly involved in
generating sales, a manager might also look at fixed asset
turnover, which measures how efficiently the company generates
sales from its investment in fixed assets.
Sales
Fixed Asset Turnover =
Fixed Assets
GFI / GF /CF1/CF 2022-2023
23
 Financial Statement Analysis
• Working Capital Ratios
– Accounts Receivable Days
• The firm’s accounts receivable in terms of the number of days’ worth of
sales that it represents
Accounts Receivable
Accounts Receivable Days =
Average Daily Sales

– Accounts Payable Days

Accounts Payable
Accounts Payable Days =
Average Daily Cost of Sales
– Inventory Days
Inventory
Inventory Days =
Average Daily Cost of Sales
– Note1 VAT treatment: the denominator can be adjusted for the VAT.
– Note 2 it is possible to consider the numerators at year end, but some
people may use the average between beginning and end of year. Be
GFI / GF /CF1/CF 2022-2023
consistent, for interpretation over time. 24
 Financial Statement Analysis
• Working Capital Ratios
– Accounts Receivable Turnover
Annual Sales
Accounts Receivable Turnover =
Accounts Receivable

– Accounts Payable Turnover

Annual Cost of Sales
Accounts Payable Turnover =
Accounts Payable

– Inventory Turnover
Annual Cost of Sales
Inventory Turnover =
Inventory
– Note same as note 2 in previous slide.

GFI / GF /CF1/CF 2022-2023

25
 Financial Statement Analysis

Problem:
• Compute Vodafone’s accounts payable days, inventory days,
and inventory turnover, based on the following data from the
balance sheet and from the income statement:
Inventory= 450
Accounts payable = 16,198
Cost of goods sold (cost of sales) = 30,505

GFI / GF /CF1/CF 2022-2023

26
Financial Statement Analysis

GFI / GF /CF1/CF 2022-2023

27
 Financial Statement Analysis
Interpret:

• Assuming that Vodafone’s accounts payable at year-end on

its balance sheet is representative of the normal amount
during the year, Vodafone is able, on average, to take about
194 days to pay its suppliers
– (This compares with 77 days you may calculate that it waits on
average to be paid - its accounts receivable days)
• Vodafone typically takes 6 days to sell its inventory
• Note that inventory turnover and inventory days tells us the
same thing in different ways – if it takes Vodafone about
5/6 days to sell its inventory, then it turns over its inventory
about 68 times per 365-day year

GFI / GF /CF1/CF 2022-2023

28
 Financial Statement Analysis

• Interest Coverage Ratios

EBIT
Interest Coverage Ratio =
Interest Expense

– Also known as times interest earned (TIE)

– TIE = Earnings divided by interest
– Can define earnings as operating income, EBIT, or EBITDA
– Assesses how easily a firm is able to cover its interest
payments

GFI / GF /CF1/CF 2022-2023

29
 Financial Statement Analysis
Problem:
• Assess Global’s ability to meet its interest obligations by
calculating interest coverage ratios using both EBIT and
EBITDA.

• Gather the EBIT, depreciation, and amortization and interest

expense for each year from Global’s Income Statement.

2015: EBIT = 7.1, EBITDA = 7.1 + 1.1, Interest expense = 4.6

2016: EBIT = 10.4, EBITDA = 10.4 + 1.2, Interest expense = 7.7

GFI / GF /CF1/CF 2022-2023

30
 Financial Statement Analysis

• In 2015 and 2016, Global had the following

interest coverage ratios:

E BIT 7.1 E BITDA 7.1 + 1.1

2015 : = =1.54 and = = 1.78
Interest 4.6 Interest 4.6
E BIT 10.4 E BITDA 10.4 + 1.2
2016 : = = 1.35 and = = 1.51
Interest 7.7 Interest 7.7

GFI / GF /CF1/CF 2022-2023

31
 Financial Statement Analysis
• Leverage (Gearing) Ratios
– Debt-Equity Ratio
• The debt-equity ratio is a common ratio used to assess a firm’s
leverage
Total Debt
Debt-Equity Ratio =
Total Equity

• This ratio can be calculated using book or market values

– Debt-to-Capital Ratio
• The debt-to-capital ratio calculates the fraction of the firm
financed by debt:

Total Debt
Debt-to-Capital Ratio =
Total Equity+Total Debt

GFI / GF /CF1/CF 2022-2023

32
 Financial Statement Analysis
• Leverage (Gearing) Ratios
– Net Debt
• While leverage increases risk to equity holders, firms may
also hold cash reserves in order to reduce risk
– Another useful measure is net debt

Net Debt = Total Debt - Excess Cash & Short Term Investments
– Debt-to-Enterprise Value Ratio
Net Debt
Debt - to - EnterpriseValue Ratio =
Enterprise Value

– Equity Multiplier
• Total Assets/Book Value of Equity
• Note1 In the Total Debt considered above we include short-term debt,
long-term debt, pension obligations, preferred shares, and minority
interest. To get net debt you take out Cash and its equivalents
• Note 2 Many others, such as solvency(E/D), or Debt/EBITDA
GFI / GF /CF1/CF 2022-2023
33
 Financial Statement Analysis
• Valuation Ratios
– Analysts and investors use a number of ratios to gauge the
market value of the firm.
• The most important is the firm’s price-earnings ratio (P/E)
• The P/E ratio is used to assess whether a stock is over- or under-valued
based on the idea that the value of a stock should be proportional to the
earnings it can generate
Market Capitalization Share Price
P /E Ratio = =
Net Income Earnings per Share
– PEG Ratio
• P/E ratios can vary widely across industries and tend to be higher for
industries with higher growth rates
• One way to capture the idea that a higher P/E ratio can be justified by
higher expected earnings growth
• It is the ratio of the firm’s P/E to its expected earnings growth rate
• The higher the PEG ratio, the higher the price relative to growth, so some
investors avoid companies with PEG ratios over 1
GFI / GF /CF1/CF 2022-2023
34
 Financial Statement Analysis
Problem:
• Consider the following data from for Campbell Soup Co. and
General Mills, Inc. ($ millions):

Campbell’s Soup Co. (CPB) General Mills, Inc. (GIS)

Sales 8,052.0 17,774.1
Operating Income 1,080.0 2,851.8
Net Income 458.0 1,855.2
Market Capitalization 13,371.0 31,660.0
Cash 333.0 741.4
Debt 7,106.0 15,018.3

• Compare Campbell’s and General Mills’ operating margin, net profit

margin, P/E ratio, and the ratio of enterprise value to operating
income and sales

GFI / GF /CF1/CF 2022-2023

35
 Financial Statement Analysis

Ratio Campbell’s General Mills

Operating Margin 1,080/8,052=13.4% 2,851.8/17,774.1 = 16.0%

Net Profit Margin 458/8,052=5.7% 1,855.2/17,774.1 = 10.4%

P/E Ratio 13,371/458 = 29.19 31,660.0/1,855.2 = 17.07

Enterprise Value 13,371.0+7,106.0-333.0 = 20,144.0 31,660.0+15,018.3 – 741.4 =

45,946.9
More examples of ratios: 20,144.0/1,080.0 = 18.65 45,936.9/2,851.0 = 16.11
Enterprise Value to
Operating Income
Enterprise Value to Sales 20,144.0/8,052.0 = 2.50 45,936.9/17,774.1 = 2.58

GFI / GF /CF1/CF 2022-2023

36
 Financial Statement Analysis

Interpret:

• Note that Campbell’s operating and net profit margins are

quite a bit lower than General Mills’.
• Campbell’s had a larger P/E ratio, which can be explained in
part by their greater use of leverage as seen later.
– However, the ratios of enterprise value to sales were almost the same
for the two firms.

GFI / GF /CF1/CF 2022-2023

37
 Financial Statement Analysis
• Investment Returns
– Return on Equity
• Evaluating the firm’s return on investment by comparing its
income to its investment
Net Income
Return on Equity =
Book Value of Equity
– Return on Assets
• Evaluating the firm’s return on investment by comparing its
income to its assets
Net Income + Interest Expense
Return on Assets =
Total Assets
• Note Sometimes you see people computing the ratios based on
“end of year” values for BE and TA; sometimes you may see people
using average values for the year. Always check and be consistent.
GFI / GF /CF1/CF 2022-2023
38
 Financial Statement Analysis

• Investment Returns
– Return on Invested Capital
• After-tax profit generated by the business, excluding interest, compared
to capital raised that has already been deployed

EBIT (1- tax rate)

Return on Invested Capital =
Book Value of Equity + Net Debt

GFI / GF /CF1/CF 2022-2023

39
 Financial Statement Analysis
• Problem:
– Assess how Global’s ability to use its assets and
invested capital effectively has changed in the last
year by computing the change in its return on assets
and in its return on invested capital.
– Regarding ROA (using end-of-year values for total
assets):

=
( 2.0 + 7.7 )
= 5.7%
( 1.9 + 4.6 )
ROA2016 ROA2015 = = 5.0%
170.1 128.9

GFI / GF /CF1/CF 2022-2023

40
 Financial Statement Analysis
– Regarding ROIC we need to compute EBIT(1-tax rate). So we
must calculate the implied tax rate:
• Because NI=PreTaxIncome(1-tax rate)
• Tax rate=1-NetIncome/PreTaxIncome = Tax Rate / Pretax
Income
– To compute the invested capital, note that net debt was:
Net Debt2016 = 5.5 + 113.2 − 23.2 = 95.5
Net Debt2015 = 3.2 + 78 − 20.5 = 60.7
– Finally:
 0.7 
10.4   1 − 
ROIC2016 =  2.7 
= 6.5%
22.2 + 95.5

 0.6 
7.1   1 − 
ROIC2015 =  2.5 
= 6.6%
21.2 + 60.7
GFI / GF /CF1/CF 2022-2023
41
 Financial Statement Analysis
• The DuPont Identity
– This expression says that ROE can be thought of as net income per
dollar of sales (profit margin) times the amount of sales per dollar of
equity

 Net Income  Sales   Net Income  Sales 

ROE =   =   
 Total Equity  Sales   Sales  Total Equity 
– This final expression says that ROE is equal to
• Net income per dollar of sales (profit margin) times
• Sales per dollar of assets (asset turnover) times
• Assets per dollar of equity (equity multiplier)

 Net Income  Sales  Total Assets   Net Income  Sales  Total Assets 
ROE =    =    
 Sales  Total Equity  Total Assets   Sales  Total Assets  Total Equity 

GFI / GF /CF1/CF 2022-2023

42
 Financial Statement Analysis
Problem:
• The following table contains information about Campbell’s (CPB) and
General Mills (GIS)
• Compute their respective ROEs and then determine how much General
Mills would need to increase its equity multiplier in order to match
Campbell’s ROE

Blank Profit Asset Equity

Margin Turnover Multiplier

Campbell’s 5.7% 0.97 6.84

General Mills 10.4% 0.78 2.97

GFI / GF /CF1/CF 2022-2023

43
 Financial Statement Analysis
• We can compute the ROE of each company by multiplying its profit
margin, asset turnover, and equity multiplier:
– Using the DuPont Identity, we have:

ROECPB = 5.7% × 0.97 × 6.84 = 37.8%

ROEGIS = 10.4% × 0.78 × 2.97 = 24.1%

• Now, using Campbell’s ROE, but General Mills’ profit margin and
asset turnover, we can solve for the equity multiplier that General
Mills needs to achieve Campbell’s ROE:
– 37.8% = 10.4% × 0.78 x Equity Multiplier

37.8%
– Equity Multiplier = = 4.67
8.1%

GFI / GF /CF1/CF 2022-2023

44
 Financial Statement Analysis:
A Summary of KeyFinancial Ratios

GFI / GF /CF1/CF 2022-2023

45
Financial Statement Analysis:
A Summary of KeyFinancial
Ratios

GFI / GF /CF1/CF 2022-2023

46