*Analysis of Financial Statements

*Key Financial StatementsBalance sheet provides a snapshot of a firms financial position at one point in time.Income statement summarizes a firms revenues and expenses over a given period of time.Statement of stockholders equity shows how much of the firms earnings were retained, rather than paid out as dividends.Statement of cash flows reports the impact of a firms activities on cash flows over a given period of time.

*Why Do We Analyze Financial Statements?A firms financial statements can be analyzed internally (by employees, managers) and externally (by bankers, investors, customers, and other interested parties).

*Why Do We Analyze Financial Statements?An internal financial analysis might be done:To evaluate the performance of employees and determine their pay raises and bonuses.To compare the financial performance of the firms different divisions.To prepare financial projections, such as those associated with the launch of a new product.To evaluate the firms financial performance in light of its competitors and determine how the firm might improve its operations.

*Why Do We Analyze Financial Statements?An external financial analysis might be done by:Banks and other lenders deciding whether to loan money to the firm.Suppliers who are considering whether to grant credit to the firm.Credit-rating agencies trying to determine the firms creditworthiness.Professional analysts who work for investment companies considering investing in the firm or advising others about investing.Individual investors deciding whether to invest in the firm.

*Methods of Analyzing Financial StatementsCommon Size StatementsTrend AnalysisFinancial RatiosDuPont Method

*Methods of Analyzing Financial Statements

Common Size Statements

*Common Size Statements Standardizing Financial InformationA common size financial statement is a standardized version of a financial statement in which all entries are presented in percentages.A common size financial statement helps to compare entries in a firms financial statements, even if the firms are not of equal size.Also called Vertical Analysis

*Common Size Statements Standardizing Financial Information (cont.)How to prepare a common size financial statement?- For a common size income statement, divide each entry in the income statement by the companys sales.- For a common size balance sheet, divide each entry in the balance sheet by the firms total assets.

*Common Size Income Statement(H. J. Boswell, Inc.)

*Common Size Balance Sheet(H. J. Boswell, Inc.)

*Methods of Analyzing Financial Statements

Trend Analysis

*Trend AnalysisTrend Analysis shows changes in the amounts of corresponding financial statement items over a period of time. It is a useful tool to evaluate the trend situations.The statements for two or more periods are used in horizontal analysis. The changes are generally shown both in amounts and percentage.Also called Horizontal Analysis

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Two Methods of Trend Analysis1. Simple base-year2. Progressive base-year

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Two Methods of Trend Analysis

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Two Methods of Trend Analysis1. Simple Base-Year Horizontal Trend Analysis

*Using Financial Ratios: Two Methods of Trend Analysis2. Progressive Base-Year Horizontal Trend Analysis

*Methods of Analyzing Financial Statements

Financial Ratios

*Financial Ratio AnalysisFinancial ratios provide a method for standardizing the financial information on the income statement and balance sheet.

A ratio by itself may have no meaning. Hence, a given ratio is compared to: ratios from previous years; or ratios of other firms in the same industry. If the differences in the ratios are significant, more in-depth analysis must be done.

*Using Financial Ratios: Types of Ratio ComparisonsTrend or time-series analysis (Horizontal Analysis)- used to evaluate a firms performance over timeCross-sectional analysis (Peer group comparison)Industry comparative analysis- compare one firms financial performance to the industrys average performanceBenchmarking- compare the firms ratio values to those of a key competitor or group of competitors that it wishes to emulateCombined analysis - uses a combination of both time series analysis and cross-sectional analysis

*Using Financial Ratios

QuestionCategory of Ratios Used1. How liquid is the firm? Will it be able to pay its bills as they become due?Liquidity ratios2. How did the firm finance its assets? Does it have the ability to repay its long-term debts? Does it have the right mix of debt and equity?Debt management or Capital structure ratios

3. How efficient has the firms management been in utilizing it assets to generate sales? Does it have the right amount of assets to support sales?Asset management efficiency ratios4. How profitable has the firm been in operating and utilizing its assets? Do sales prices exceed unit costs? Are sales high enough? Profitability ratios

5. What do investors think about the firm and its future prospects? Do investors like what they see?Market value ratios

*Financial Ratios

Liquidity Ratios

*Liquidity RatiosThe liquidity of an asset refers to the speed with which the asset can be converted into cash without loss of value. The liquidity of a firm as a whole is its ability to regularly convert its current assets into cash so that it can pay its bills on time. This is a function of both the liquidity of the firms current assets and the size of the bills it must pay

*Liquidity RatiosWe can analyze a firms liquidity from two perspectives:Overall liquidity is analyzed by comparing the firms current assets to the firms current liabilities.Liquidity of specific assets is analyzed by examining the timeliness in which the firms primary liquid assets accounts receivable and inventories are converted into cash.

*Liquidity Ratios: Current RatioThe overall liquidity of a firm is analyzed by computing the net working capital, current ratio, acid-test ratio, and cash ratio.Net Working Capital the difference between the firms current assets and current liabilities = Current Assets Current Liabilities

*Liquidity Ratios: Current RatioCurrent Ratio: Current Ratio compares a firms current (liquid) assets to its current (short-term) liabilities.

*Liquidity Ratios: Quick or Acid-Test RatioThe Acid-Test (Quick) Ratio excludes the inventory from current assets as inventory may not always be very liquid.

*Quick Assets = Cash + Cash Equivalents + Accounts Receivable

*Liquidity Ratios: Cash RatioThe cash ratio is an indicator of a company's liquidity that further refines both the current ratio and the quick ratioby measuring the amount of cash and cash equivalents to cover current liabilities. Cash + Cash EquivalentsCash Ratio = ------------------------------------ Current Liabilities

*Liquidity Ratios: Individual Asset Categories We can also measure the liquidity of the firm by examining the liquidity of individual current asset accounts, including accounts receivable and inventories.We can assess the liquidity of the firm by measuring how long it takes the firm to convert its accounts receivable and inventories into cash.

*Liquidity Ratios: Accounts ReceivableAverage Collection Period (Days Sales Outstanding) measures the number of days it takes the firm to collect its receivables.

OR365 days Accounts Receivable Turnover

*Liquidity Ratios: Accounts Receivable Turnover RatioAccounts Receivable Turnover Ratio measures how many times accounts receivable are rolled over during a year.

365 days Average Collection PeriodORWhen computing a ratio that uses data from both the income statement and the balance sheet, it is better to use the average balance of the data coming from the balance sheet if available.

*Liquidity Ratios: Accounts PayableAverage Payment Period measures the number of days a company takes to pay off credit purchases. Accounts Payable Average Payment Period = --------------------------------------------- (Total Annual Credit Purchases 365)Average Daily Purchases = 365 Accounts Payable Turnover OR

*Liquidity Ratios: Accounts Payable

Annual Credit PurchasesAccounts Payable Turnover = --------------------------------------- Accounts Payable

*Liquidity Ratios: Inventory Turnover RatioInventory turnover ratio measures how many times the company turns over its inventory during the year. Shorter inventory cycles lead to greater liquidity since the items in inventory are converted to cash more quickly.Note: Some books use Sales instead of Cost of Goods Sold.

*Liquidity Ratios: Days Sales in InventoryWe can express the inventory turnover ratio in terms of the number of days the inventory sits unsold on the firms shelves (average age of inventory). 365Days Sales = ------------------------------------ in Inventory Inventory Turnover Ratio

*Liquidity Ratios: Interval RatioThe interval measure is used to measure the burn rate or how fast you "burn" through current assets in your business. A calculation used to measure the approximate number of days a company could operate simply on the current assets it currently has on hand. An interval measure is a financial ratio used to determine the length of time a firm can continue everyday business with using current assets in the event of a halt of inflow.

*The Operating Cycle (OC) is the time between ordering materials and collecting cash from receivables.The Cash Conversion Cycle (CCC) is the time between when a firm pays its suppliers for inventory (cash outflow for payables) and collecting cash from the sale of the finished product (cash inflow from collections).Cash Conversion Cycle

*Cash Conversion CycleBoth the OC and CCC may be computed as shown below.

*Timeline for IBMs Cash Conversion Cycle

*Can a Firm Have Too Much Liquidity?A high investment in liquid assets will enable the firm to repay its current liabilities in a timely manner.

However, an excessive investment in liquid assets can prove to be costly as liquid assets (such as cash) generate minimal return.

*Financial Ratios

Capital Structure or Debt Management Ratios

*Capital Structure/Debt Management RatiosCapital structure ratios address the question: How has the firm financed the purchase of its assets?

*Capital Structure/Debt Management Ratios Debt ratio (or Debt-to-Asset Ratio) measures the proportion of the firms assets that are financed by borrowing or debt financing.

*Capital Structure/Debt Management RatiosThe debt-to-equity (D/E) ratio is also used in financial analysis. It indicates to what extent owners equity can cushion creditors claims in the event of liquidation.

*Capital Structure/Debt Management Ratios The debt-to-asset (D/A) and debt-to-equity (D/E) ratios are simply transformations of each other: D/E = D/A (1 D/A) and D/A = D/E (1 + D/E)

*Capital Structure/Debt Management RatiosThe equity multiple (EM) measures how many pesos of assets a firm supports with each peso of capital. If a firm is totally financed by equity, the equity multiplier will equal 1.00, while the larger the number, the more highly leveraged is the firm. EM = Total Assets or 1 + Total DebtTotal Equity Total Equity

*Capital Structure/Debt Management Ratios Times Interest Earned Ratio measures the ability of the firm to service its debt or repay the interest on debt.

We use EBIT or operating income as interest expense is paid before a firm pays its taxes.

*Capital Structure/Debt Management Ratios The EBITDA Coverage Ratio is more complete than the TIE ratio because it recognizes that depreciation and amortization are not cash charges and thus are available to service debt and that lease payments and principal payments on debt are fixed charges.

*Capital Structure/Debt Management Ratios

EBITDA + Lease paymentsEBITDA =Coverage Interest + Principal Payments + Lease Payments

*Capital Structure/Debt Management RatiosThe Cash Coverage Ratio is useful for determining the amount available to pay for interest. The ratio should be substantially greater than 1:1.

Cash Coverage Ratio = EBITDA Interest Expense

*Financial Ratios

Asset Management Efficiency Ratios

*Asset Management Efficiency RatiosAsset management efficiency ratios measure a firms effectiveness in utilizing its assets to generate sales. They are commonly referred to as turnover ratios as they reflect the number of times a particular asset account balance turns over during a year.

*Asset Management Efficiency Ratios Total Asset Turnover Ratio represents the amount of sales generated per peso invested in firms assets. SalesTotal Asset Turnover = ------------------- Total Assets

*Asset Management Efficiency Ratios Fixed asset turnover ratio measures firms efficiency in utilizing its fixed assets (such as property, plant and equipment). Sales Fixed Asset = ------------------------------------- Turnover Net Plant & Equipment

*Asset Management Efficiency Ratios We could similarly compute the turnover ratio for other assets.

We had earlier computed the receivables turnover and inventory turnover, which measured firm effectiveness in managing its investments in accounts receivables and inventories.

*Financial Ratios

Profitability Ratios

*Profitability RatiosProfitability ratios address a very fundamental question: Has the firm earned adequate returns on its investments? We answer this question by analyzing the firms profit margin, which predicts the ability of the firm to control its expenses, and the firms rate of return on investments.

*Profitability Ratios (cont.)Two fundamental determinants of firms profitability and returns on investments are:Cost ControlIs the firm controlling costs and earning reasonable profit margin?Efficiency of asset utilizationIs the firm efficiently utilizing the assets to generate sales?

*Profitability Ratios Gross profit margin shows how well the firms management controls its expenses to generate profits.

*Profitability Ratios Operating Profit Margin measures how much profit is generated from each peso of sales after accounting for both costs of goods sold and operating expenses. It thus also indicates how well the firm is managing its income statement. Operating Net Operating Income or EBIT Profit = ---------------------------------------------------- Margin Sales

*Profitability Ratios Net Profit Margin measures how much income is generated from each peso of sales after adjusting for all expenses (including income taxes).

*Profitability Ratios Return on Assets ratio is a measure of net profit per peso of asset. Net Income Return on Assets = ----------------------- Total Assets

*Profitability Ratios Basic Earning Power (BEP) is useful for comparing firms in different tax situations and with different degrees of financial leverage. Also called Operating Return on Assets (OROA) EBIT Basic Earning Power = ---------------------------Total Assets

*Profitability Ratios (cont.)Decomposing the OROA ratio: We can use the following equation to decompose the OROA ratio that allows us to analyze the firms ability to control costs and utilize its investments in assets efficiently.

*Profitability RatiosReturn on Common Equity ratio measures the accounting return on the common stockholders investment.

*Financial Ratios

Market Value Ratios

*Market Value RatiosMarket value ratios address the question, how are the firms shares valued in the stock market?

*Market Value Ratios (cont.)Price-Earnings (PE) Ratio indicates how much investors are currently willing to pay for every peso of reported earnings.

*Market Value Ratios Market-to-Book Ratio measures the relationship between the market value and the accumulated investment in the firms equity.

*Market Value Ratios Book Value per Share calculates the per share value of a company based on its equity available to common shareholders

Total equity Book value of preferred stock---- Total number of common shares outstandingBook Value per Common Share =

*Market Value Ratios The dividend yield shows how much a company pays out in dividends each year relative to its share price.

*Methods of Analyzing Financial Statements

The DuPont Model

*DuPont System of AnalysisThe DuPont system of analysis is used to dissect the firms financial statements to assess its financial condition.The system uses three financial ratios to express the ROA and ROE: Profit Margin Ratio, Asset Turnover Ratio, and Equity Multiplier.

*Using the DuPont Method for Decomposing the ROE ratioDuPont method analyzes the firms ROE by decomposing it into three parts: profitability, efficiency and an equity multiplier.

ROE = Profitability Efficiency Equity Multiplier

Equity multiplier captures the effect of the firms use of debt financing on its return on equity. The equity multiplier increases in value as the firm uses more debt.

Equity multiplier = Total Assets Total Equity or = 1 (1 D/A)

*The DuPont SystemFocuses on expense control, asset utilization, and debt utilization.ROE = Profitability Efficiency Equity Multiplier

*Using the DuPont Method for Decomposing the ROE ratio (cont.)

*Other ratiosEarnings per share (EPS) Net Working Capital to Total Assets Net Working Capital TurnoverCapital Intensity RatioDividend Payout Ratio

*The Limitations of Ratio AnalysisPicking an industry benchmark can sometimes be difficult.Published peer-group or industry averages are not always representative of the firm being analyzed.An industry average is not necessarily a desirable target or norm. Accounting practices differ widely among firms.

*The Limitations of Ratio Analysis Many firms experience seasonal changes in their operations.Financial ratios offer only clues. We need to analyze the numbers in order to fully understand the ratios.The results of financial analysis are dependent on the quality of the financial statements.Window dressing techniques can make statements and ratios look better.

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