Financial Statement Analysis

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Financial Statement

Analysis

1
Objective of a Business
• Create value for its shareholders while
maintaining a sound financial position.
• Return on investment.
• Sound financial position.
• Other important objectives include:
– Employee satisfaction.
– Social responsibility.
– Ethical considerations.

2
Stock Price
Expected Market
Cashflows Conditions

NPV
Timing of
MVA Stock Price
Cashflows
EVA

Risk of
Cashflows

3
Financial Statement Analysis Tools

 Common - Size Statements


 a standardized financial statement expressing all
items in percentage terms
• The balance sheet as a % of assets and
• The income statement as a % of sales
 Common-Base Year Financial Statement -
Trend Analysis
 A standardized financial statement presenting all
items relative to a certain base year amount
• useful in trend analysis
• lends itself to plotting the trends graphically
4
Financial Statement Analysis Tools

• Horizontal analysis
• Vertical analysis express each item on the statement
as a percentage.
• EIC Analysis
• Comparative statement
• Time series
• Prediction of bankruptcy

5
Common-Size Balance Sheet
Assets 1999 2000
Current Assets
Cash 2.8% 2.7%
Accounts receivable 16.1 16.8
Inventory 19.9 20.9
Total 38.8% 40.4%
Fixed assets
Net plant and equipment 61.2% 59.6%
Total assets 100% 100%
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Common-Size Balance Sheet (continued)
Liabilities and equity 1999 2000
Current liabilities
Accounts payable 13.0% 14.1%
Notes payable 6.8 9.5
Total 19.9% 23.6%
Long-term debt 12.7% 12.2%
Stockholders’ equity
Common stock and
paid-in surplus 18.0% 15.7%
Retained earnings 49.4 48.5
Total 67.4 64.2
Total liabilities and equity 100% 100%
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Common-Size Income Statement
Net sales 100.0 %
Cost of goods sold 67.6
Depreciation 4.2
Earnings before interest
and taxes 28.2
Interest 2.8
Taxable income 25.4
Taxes 7.5
Net income 17.8 %
Dividends 3.7 %
Addition to retained earnings 14.1 %
8
Evaluating Financial Ratios
 Financial
ratios are evaluated using three types
of comparisons.
 Time-series comparisons - comparisons of a
company’s financial ratios with its own historical
ratios
 Benchmarks - general rules of thumb specifying
appropriate levels for financial ratios
 Cross-sectional comparisons - comparisons of a
company’s financial ratios with the ratios of other
companies or with industry averages
9
Ratios
 Financial analysis using ratios is useful to
investors because the ratios capture critical
dimensions of the economic performance of the
company.
 Managers use ratios to guide, measure, and
reward workers.
 Often companies base employee bonuses on a
specific financial ratio or a combination of some
other performance measure and a financial ratio.
10
Ratios- a double edged weapon
 Ratios mean different things to different groups.
 A creditor might think that a high current ratio is
good because it means that the company has the
cash to pay the debt.
 However, a manager might think that a high current
ratio is undesirable because it could mean that the
company is carrying too much inventory or is
allowing its receivables to get too high.

11
Cont…
 GAAP does not define ratios.
 Multiple equally valid approaches to ratios and
analysis.
 Managers (e.g., division manager, sales manager)
should be measured to items that they control.
 Investors and top management are most interested
in overall performance or broadest measures of
performance.
 Understanding less broad measures of performance may
give additional insight into overall performance.

12
Structure of analysis
• From broadest to more specific levels.
 Principal value of financial analysis:
 Ratio comparisons start with the supposition that all
other things are equal. (They rarely are.)

13
Categories of ratios which measure:
Overall performance are
– Profitability
– Investment utilization
– Financial condition
– Dividend policy

14
Financial Ratios
 A financial ratio combines multiple values to
produce a new, meaningful value
 Used to quantify, summarize and interpret financial data
 Types of ratios
 Solvency or liquidity ratio
• Measure firm’s ability to meet short-term obligations
 Turnover ratios
• Measure rate of activity
 Coverage ratios
• Measure extent to which the firm’s earnings can cover debt-
related expenses

15
Financial Ratios
 Leverage ratios
• Measure extent to which firm has been financed by creditors
 Profitability ratios
• Measures productivity of money invested in firm
 Per share data
• Examines items that affect common stock’s market price per
share
 Growth ratios
• Measures contribution of various items to firm’s development
 Risk analysis ratios
• Measures variability

16
Making comparisons
 Finding the appropriate standard is difficult.
 A high ratio (e.g., current ratio, ROI) may be
good or bad. It can’t be viewed in isolation.
 Is a high CR good or bad?
 Is a high ROI always good?
 Values of ratios compared across time 
trend analysis.

17
Overall Measures
• Return on investment (ROI) = net income /
investment
 Possible definitions of investment: assets, owners’
equity, invested capital.
 Possible definitions of return: net income, net
income -preferred dividends, net income +
interest expense (1-tax rate).

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Return on assets (ROA)
 (net income + interest(1-tax rate))/ total
assets.
 How well management is using a pool of capital .
 Some analysts ignore the interest adjustment.
 Measures how an enterprise uses its funds.
 May be used to evaluate individual business units in a
large company

19
Return on shareholders’ equity (ROE)

 Net income/shareholders’ equity.


 Or, (net income -preferred dividends) /
Common shareholders’ equity.
 Common shareholders’ equity = total shareholders’
equity - preferred stock.
 Reflects return on funds invested by shareholders.
 Of interest to current and prospective
shareholders.

20
Return on invested capital (ROIC)
 (net income + interest(1-tax rate))/ invested
capital
 Invested capital = permanent capital = capital
employed
 = long-term liabilities + shareholders’ equity
 Or = working capital + non-current assets.
 Return on funds entrusted to the firm for
relatively long time.

21
Variations
 Average or weighted average investment is
more representative (e.g., (beginning +
ending)  2).
 Tangible assets instead of total assets.

22
DuPont Identity
• The DuPont Identity is essentially just an
expanded version of ROE. It is used to
compare two companies’ profitability,
efficiency, and leverage.
Net Income X Sales X Assets
Sales Assets Equity
– By breaking down ROE into these three things, it
allows you to determine exactly why one
company has a better ROE than another.

23
Relationship of ROE to Profit Margin,
Asset & Leverage
• ROE can be viewed as:
Pretax margin percentage X Asset Turnover ratio X
Financial leverage ratio X Tax retention rate.
 ROE =
Pretax profit/sales revenue X (sales revenues / total
assets) X (Total assets/Shareholders’ equity) X (1- Tax
rate)
 How do we improve ROE?

24
ROE
Return on Assets
(Profitability) Financial

leverage
Liquidity
Net profit Asset
 Solvency
Margin turnover

Net income / Sales Sales / Total assets


Current
Fix assets
Sales — Total cost assets +
COGS Cash Land
SG&A Acc. Receivables Building
R&D Inventory Equipment
Interest expense Other Intangibles
Income taxes Others
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The Du Pont Identity-ROA Version

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Price/Earnings (PE) ratio
 Measure of overall performance.
 Market price per share/EPS
 Market price is not controlled by company;
reflects all information available to the market.
 Reflects how investors judge the future
performance or prospects of the company.
 Commonly compared to other companies in the
same industry.

27
Earnings per share
• Company ABC has an EPS of $5 per share,
Company XYZ has an EPS of $10 per share.
• Is one a better company or investment than
the other? Is one more profitable than the
other?

28
Profitability measures

 Profit margin = net income/net sales = a


measure of overall profitability.

29
Investment utilization measures
• How well are assets managed.
Profitability measures focus on Income
Statement.
Investment utilization measures involve
balance sheet and income statement
amounts.

30
Investment turnover
 Asset turnover = Sales revenue/total assets.
 Invested capital turnover = Sales
revenue/invested capital.
 Equity turnover = Sales revenue/shareholders’
equity.

31
Capital intensity
 Capital intensity ratio = sales revenue/PPE =
fixed asset turnover.

32
Working capital measures
 Days’ cash = cash/cash costs per day =
cash/(cash expenses  365)
 Cash expenses = total expenses - depreciation -
other non-cash expenses.
 Days’ receivables = Receivables/(sales  365)
 Days’ inventory = inventory/(cost of goods
sold  365)
 Inventory turnover = cost of goods sold/inventory

33
Working capital measures
 Days’ payables = operating payables/(pretax
cash expenses  365).
 Approximate pre-tax cash expenses = all expenses
except taxes - depreciation expense.
 Working capital turnover = sales revenue/
working capital
 Some analysts look at the ratio of working capital
to sales revenue (the inverse of working capital
turnover)
34
Cash conversion cycle
 Receivables conversion period (i.e., days’
receivables) + inventory conversion period
(i.e., days’ inventory) - payment deferral
period (i.e., days’ payables) = operating cycle -
payment deferral period.
 A measure of liquidity.
 Indicates time interval for which additional short-
term financing might be needed to support a
spurt in sales.
35
Financial condition ratios
• Liquidity
• Solvency

36
Liquidity
 Ability to meet current obligations.
 Tests for size and relationship between current
liabilities and current assets.
 Liquidity measures:
 Current ratio = current assets/current liabilities.
 Acid Test (or quick) ratio = monetary current
assets / current liabilities
 Monetary current assets = current assets - inventory -
prepaid assets.

37
Solvency
 Ability to meet interest costs and repayment
schedules associated with long-term debt.
 Solvency measures
 Debt/equity ratio = total liabilities/shareholders’
equity
 Alternatively, Debt/equity ratio = long-term
liabilities/shareholders’ equity.
 Debt/capitalization ratio = long-term debt/total
invested capital.

38
Solvency Measures
 Total invested capital = long term debt +
shareholders’ equity.
 Times interest earned = income before
interest/interest expense
 Ratio of Cash generated by operations to total
debt

39
Credit Risk Analysis
• Procedure to determine the likelihood a customer
will pay its bills. Consider the customer’s previous
credit history, bank or trade references, financial
statements, and any other information supplied by
the customer or collected.
• Credit agencies provide reports on the credit
worthiness of a potential customer.
• Financial ratio analysis can be used to help determine
a customer’s ability to pay its bills.

40
Credit Risk Analysis
A technique used to develop a measurement
of solvency, sometimes called a Z Score.
Edward Altman developed a Z Score formula
that was able to identify bankrupt firms
approximately 95% of the time.

41
Credit Risk Analysis

Altman Z Score formula

EBIT sales market value of equity


Z = 3.3 + 1.0 + 0.6
total assets total assets total book debt

retained earnings working capital


+ 1.4 + 1.2
total assets total assets

42
Credit Risk Analysis
Example - If the Altman Z Score cut off for a
credit worthy business is 2.7 or higher, would we
accept the following client?

EBIT
 1.2
total assets retained earnings
 0.4
total assets
sales
 1.4
total assets
working capital
 0.12
market equity
 0.9 total assets
book debt
43
Credit Risk Analysis
Example - If the Altman Z Score cut off for a credit
worthy business is 2.7 or higher, would we accept
the following client?
Firm' s Z Score
 (3.3 x 0.12)  (1.0 x 1.4)  (0.6 x 0.9)
 (1.4 x 0.4)  (1.2 x 0.12)  3.04

A score above 2.7 indicates good credit.


44
Credit Risk Analysis
• Credit analysis is only worth while if the
expected savings exceed the cost.
– Don’t undertake a full credit analysis unless the
order is big enough to justify it.
– Undertake a full credit analysis for the doubtful
orders only.

45
Trading on the Equity
 Capitalization
(capital structure) - the total of a
company’s long-term financing
 Owners’ equity plus long-term debt

 Trading on the equity (financial leverage,


leveraging) - using borrowed money at fixed
interest rates with the objective of enhancing
the rate of return on common equity

46
Trading on the Equity
 There are costs and benefits to the
shareholders from leveraging.
 Costs:
• Interest payments
• Increased risk
 Benefits:
• Larger returns to the common shareholders, as
long as overall income is large enough to cover the
increased interest payments

47
Dividend policy
• Dividend yield = dividends per share/ market
price per share
 Dividend pay-out = dividends/net income
 Provides info on how growth is financed.
 Less dividends paid means more earnings are
retained to fund growth.

48
Growth measures
• Key accounting items for which growth is
computed: sales, net income, earnings per
share.
 Average growth = (growth per year for n
years)/n
 Compound growth rate = based on present
value concepts.
 May be misleading due to abnormally high or low
beginning or ending year.

49
Implied growth rate
=Return on shareholders’ equity X Profit
retention rate

= ROE X (1 – Dividend payout)


• Estimates potential to grow profits without an
injection of new capital.

50
Analysis of Growth
 Common stock price appreciation depends on
various factors
 Growth financed internally depends on the amount of
retained earnings
 A corporation’s growth rate depends on the return on
equity
• Growth rate = RR x ROE
Shows that multiple
 Substituting the three-part DuPont ROE equation, we obtain
factors influence
growth—one factor Sales Total assets Net income
Growth rate  RR   
can rise and another Total assets Equity Sales
fall and growth can
remain unchanged.
51
Bases for comparison

 Experience. A feel for what is right or reasonable.


 Budget. A target developed within the company.
Factors to be considered:
 How carefully was budget constructed?
 What circumstances are different now?
 Historical standards. Prior period’s results
adjusted for changes in accounting methods.
• External benchmarks. Competitor, industry
average

52
Ratio Standards of Comparison
 Cross-Sectional standards
 Compare a firm’s financial ratios to other firms or
industry average
• Industry averages are published by companies such as
 Moody’s
 Standard & Poor’s
 Value Line
 Can reveal a firm’s strengths/weaknesses compared to
other firms

53
Ratio Standards of Comparison
 Time-Series standards
 Compare a firm to its own ratios from other
years
• Helps highlight trends/changes that have occurred

54
Potential Problems with Financial Analysis

 Inflation distortions
 Can be a serious problem with the balance sheet
• Some fixed assets are reported at their historical costs
 After several years of high inflation historical costs can be
irrelevant
 Vague definition of accounting income
 A firm can modify its accounting income depending
upon certain actions
• Such as which depreciation method or inventory valuation
technique is used

55
Potential Problems with Financial Analysis
 Consolidated financial statements
 When a firm owns a subsidiary corporation
accounting issues arise when considering
minority interests
 Goodwill
 When a company merges, oftentimes ‘goodwill’
is then reflected on the consolidated balance
sheet
• This intangible asset cannot be measured with
precision

56
Comments on Ratio Analysis
• Helps paint a picture.
• Try to overcome tendency to look at numbers
rather than underlying reasons.
• Starting point; identifies questions not
answers.

57
Financial Ratios
Short-term liquidity ratios

Name of Ratio Numerator Denominator

Current ratio Current assets Current liabilities

Quick ratio Cash + Marketable Current liabilities


securities + Receivables

Average collection Average accounts Sales


period in days receivable x 365

Inventory turnover Cost of goods sold Average inventory at


cost

58
Financial Ratios
Long-term solvency ratios

Name of Ratio Numerator Denominator

Total debt to total assets Total liabilities Total assets

Total debt to equity Total liabilities Stockholders' equity

Interest coverage Income before interest Interest expense


and taxes

59
Financial Ratios
Profitability ratios
Name of Ratio Numerator Denominator
Return on stockholders' Net income Average stockholders'
equity equity
Gross profit rate or Gross profit or gross margin Sales
percentage

Return on sales Net income Sales


Asset turnover Sales Average total assets
available
Pretax return on operating Operating income Average total assets
assets available
Earnings per share Net income less dividends Average common shares
on preferred stock, if any outstanding
60
Financial Ratios
Market price and dividend ratios
Name of Ratio Numerator Denominator

Price-earnings Market price of common Earnings per share


stock
Dividend yield Dividends per common Market price of common
share stock
Dividend-payout Dividends per common Earnings per share
share

61
What is EVA?
• EVA = Economic profit
– Not the same as accounting profit
• Difference between revenues and costs
– Costs include not only expenses but also cost of capital
– Economic profit adjusts for distortions caused by
accounting methods
• Doesn’t have to follow GAAP
– Cost of capital accounted for explicitly
• Rate of return required by suppliers of a firm’s debt and equity
capital
• Represents minimum acceptable return.
Components of EVA
• NOPAT
– Net operating profit after tax
• Operating capital
– Net operating working capital, net PP&E, goodwill,
and other operating assets
• Cost of capital
– Weighted average cost of capital %
• Capital charge
– Cost of capital % * operating capital
• Economic value added
– NOPAT less the capital charge.
What is NOPAT?
Net sales 150,000
Cost of sales 135,000
Depreciation 2,000
SG&A 7,000
Net Operating profit 6,000
Taxes @ 40% 2,400
NOPAT 3,600
What is Operating Capital?
• Capital: Net operating assets adjusted for
certain accounting distortions
– Asset write-downs, restructuring charges, …
• Net operating assets:
– Cash, receivables, inventory, pre-paid
– Trade payable, accruals, deferred taxes
– Net property, plant, and equipment
• Exclude non-operating assets:
– Marketable securities, investments,...
What is Cost of Capital?

• Weighted average cost of capital consists of:


Cost of debt after taxes
= Market interest rate x (1 – tax rate)
Cost of equity
= Risk-free rate + beta x (market risk premium)
WACC
= Cost of debt after taxes x % debt +
cost of equity x % equity
where % debt + % equity = 100%.
What is the Capital Charge?

• Represents a rental charge for the use of the


operating capital.
• Minimum rate of return the operating capital
should earn.
• Calculated as the firm’s weighted average cost of
capital % x invested capital.
Calculating EVA
Return on invested operating capital (ROIC)
=NOPAT/Average capital
Economic value added (EVA)= (ROIC - WACC) *
Operating capital
Fundamental Strategies
 NOPAT 
EVA    Cost of capital * Capital
 Capital 

Operate: Improve the Decrease: WACC


return on existing
operating capital
Build: Invest as long as returns
exceed the cost of capital

Harvest: Re-deploy capital when returns fail to achieve


the cost of capital.
What’s Affecting EVA?
Sales
- Operating expenses
- Taxes
= NOPAT
Net working capital
- Capital charge PP&E
WACC
= EVA
Forward Looking Relationship for
EVA & MVA
EVA EVA EVA EVA
Year 1 Year 2 Year 3 .... Year n

MVA

Market EVA + EVA + EVA + ... + EVA


value = 1+r (1 + r)2 (1 + r)3 (1 + r)n
Capital
Market value is based on establishing the
economic investment made in the company
(capital), making a best guess about what
economic profits (EVA) will happen in the
future, and discounting those EVAs to the
present to get market value added.
EVA Drives MVA
Companies that consistently earn profits in
excess of their required return ...

EVA
NOPAT
Charge

… are typically valued at premiums to book value.

Market MVA
Value

Capital
Focus on EVA Improvement
• A positive change in EVA is better than a
positive yet unchanging base level of EVA
– Why?
• Positive changes in EVA are consistent with the
managerial notion of continuous improvement in
performance.

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