ac315 chapter 5 lecture
TRANSCRIPT
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CHAPTER 5
ESSENTIALS OF FINANCIAL
STATEMENT ANALYSIS
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Roadmap
Two concepts
Cross-sectional vs. Time-series
Common-size vs. Trend Statement
Profitability analysis
Credit risk analysis
Return on equity and financial leverage
analysis
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Basic ApproachesBasic Approaches
A. Time-series analysis helps identifyfinancial trends over time for a single
company or business unit.
B. Cross-sectional analysis helps identifysimilarities and differences across
companies or business units at a singlemoment in time.
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Common sizeand trend
statements 1. Common size income statements recast
each statement item as a percentage of sales
for that period.
2. Trend statements recast each statement
item as a percentage of that item in a base
year.
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Profitability, Competition, and
Business Strategy
A. Financial ratios are another
powerful tool that analysts use in
evaluating profit performance and
assessing credit risk.
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Profitability, Competition, and
Business StrategyMost evaluations of profit
performancebegin with the return on
assets (ROA) ratio.
ROA = NOPAT/Average Assets
1. A companys sustainable operatingprofits are isolated by removingnonoperating or nonrecurring items fromreported earnings.
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Profitability, Competition, andBusiness Strategy
2. After-tax interest expense is eliminatedfrom the profit calculation so that operatingprofitability comparisons over time are notclouded by differences in financial structure.
3. Adjustments to eliminate distortions to bothearnings & assets for items such as off-balancesheet operating leases.
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Profitability, Competition, and
Business Strategy
A company can increase its ROA intwo different ways:
1. By increasing the operating profitmargin.
2. By increasing the intensity of assetutilization.
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Profitability, Competition, and
Business Strategy In other words, ROA can be thought of as:
a. Oper. profit margin v asset turnover ,or
b. NOPAT/SALES X SALES/AVG. ASSETS
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Credit Riskand CapitalCredit Riskand Capital
StructureStructureA. Credit riskrefers to theability and
willingness ofaborrower to pay its debt. 1. Ability to repay debt is determined by capacity
to generate cash from operations, asset sales, orexternal financial markets in excess of cash needs.
2. Willingness to pay depends on whichcompeting cash need is viewed as the most
pressing at the moment.
3. The statement of cash flows is an importantsource of information for analyzing a companyscredit risk. Financial ratios are also useful for this
purpose.
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Credit Riskand CapitalCredit Riskand Capital
StructureStructureB. Credit riskanalysisusing financialratios typically involvesan assessment of
liquidity and solvency.
1. Liquidity refers to the companys short-term ability to generate cash for workingcapital needs and immediate debt repaymentneeds.
2. Solvency refers to the long-term ability togenerate cash internally or from externalsources in order to satisfy plant capacityneeds, fuel growth, and repay debt when due.
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Credit Riskand CapitalCredit Riskand Capital
StructureStructureShort-term liquidity:
Current Ratio = CA/CL
reflects cash as well as amounts that will be
converted into cash in the normal
operating cycle.
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Inventory is eliminated, providing a moreshort-run reflection of liquidity, since fewbusinesses can instantaneously converttheir inventories into cash.
Credit Riskand CapitalCredit Riskand Capital
StructureStructureShort-term liquidity:
QuickRatio = (CA-INV)/CL
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Credit Riskand CapitalCredit Riskand Capital
StructureStructureShort-term liquidity:
A/R Turnover = Net Sales / Avg. A/R
This ratio tells users the proportion of yearlysales that the average receivables balance
represents. This ratio will be correspondinglylarger for firms with cash sales that are alarger proportion of total sales.
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Credit Riskand Capital StructureCredit Riskand Capital StructureShort-term liquidity:
Days Receivable Out. = 365 A/R Turnover
This ratio tells users the average collection
period for accounts receivable. This shouldbe compared to the credit period allowed bythe company.
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Credit Riskand Capital StructureCredit Riskand Capital StructureShort-term liquidity:
Inventory Turnover Ratio = COGS / AVG.INV.
This ratio tells users the proportion of sales that
the average inventory balance represents. Ahigher ratio may indicate:i. More efficient operations, orii. Adoption of a low-cost leadership
strategy.
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Credit Riskand Capital StructureCredit Riskand Capital StructureShort-term liquidity:
Days Inventory Held = 365Days
INV. TURNOVER
This ratio tells users the average number of
days that inventory is held in storage.
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Credit Riskand Capital StructureCredit Riskand Capital StructureShort-term liquidity:
A/P Turnover = Inventory PurchasesAvg. A/P.
This ratio, and its counterpart that follows, helpsanalysts understand the companys pattern ofpayment to suppliers.
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Credit Riskand Capital StructureCredit Riskand Capital Structure
Short-term liquidity:
Days A/P Outstanding = 365 days
A/P Turnover
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Credit Riskand Capital StructureCredit Riskand Capital Structure
Short-term liquidity:
+ days receivable outstanding
+ days inventory held
- days accounts payable outstanding
Differenceto get a measure of the mismatching of cash inflows
and outflows. The level of concern is negativelycorrelated with the level of operating cash flow.
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Credit Riskand Capital StructureCredit Riskand Capital Structure
Long-term solvency:
1. Debt ratios provide information about
the amount of long-term debt in a
companys financial structure.
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Credit Riskand Capital StructureCredit Riskand Capital Structure
Long-term solvency:
2. L-Term Debt to Assets = Long-Term Debt
Total Assets
reflects the proportion of each asset dollar
financed with long-term debt.
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Credit Riskand Capital StructureCredit Riskand Capital Structure
Long-term solvency:
3. L-T Debt to
Tangible Assets = L-T Debt
Total Tangible Assets
The adjustment to remove intangible assets is
intended to remove soft assets, i.e., those
that are difficult to value reliably.
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Credit Riskand Capital StructureCredit Riskand Capital Structure
Long-term solvency:
4. Interest Coverage = Operating Incomebefore taxes &Int. Exp
Interest Expense
While debt ratios are useful for understanding thefinancial structure of a company, they provide no
information about its ability to generate a stream ofinflows sufficient to make principal and interestpayments. The interest coverage ratio iscommonly used for this purpose.
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Credit Riskand Capital StructureCredit Riskand Capital Structure
Long-term solvency: 5. Operating Cash
Flows to Total Liabilities = CFOPAAvg. CL +L-T
Debt
This ratio shows the ability of a company togenerate cash flows from operations in order to
service both short-term and long-termborrowings.
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Return on Equity andReturn on Equity and
Financial LeverageFinancial Leverage A. Profitability and credit risk
both influence the return that
common shareholders earn on theirinvestment in the company.
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Return on Equity and
Financial Leverage
B. Return on C/E (ROCE) =
NI available to Common ShareholdersAvg. Common SE
This ratio measures a companys
performance in using capital provided byshareholders to generate earnings.
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Return on Equity and Financial
LeverageC. Components of ROCE:
1.ROCE = ROAv common earnings leverage v financialstructure leverage
or
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Return on Equity and Financial
LeverageC. Components of ROCE:
2. ROCE =NOPAT X NI AVAIL. TO COMMON X AVG. ASSETS
AVG. ASSETS NOPAT AVG. COMMONSE
a. The common earnings leverage ratio showsthe proportion of NOPAT that belongs to common
shareholders.b. The financial structure leverage ratiomeasures the degree to which the company usescommon shareholders capital to finance assets.
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Roadmap
Two concepts
Cross-sectional vs. Time-series
Common-size vs. Trend Statement
Profitability analysis
Credit risk analysis
Return on equity and financial leverage
analysis