Chapter 14

ANALYSIS OF FINANCIAL STATEMENTS

Major Financial Statements

Corporate shareholder annual and quarterly reports must include:Balance sheet Income statementStatement of cash flows

Reports filed with Securities and Exchange Commission (SEC)10-K and 10-Q

Generally Accepted Accounting Principles

GAAP are formulated by the Financial Accounting Standards Board (FASB)

Provides some flexibility of accounting principles Can be good for firms in different situations Can represent a challenge for analysis Financial statements footnotes must disclose

which accounting principles are used by the firm

Balance Sheet

Shows resources (assets) of the firm and how it has financed these resources (liabilities and equity)Indicates current and fixed assets available at a point in time (snapshot)Financing is indicated by its mixture of current liabilities, long-term liabilities, and owners’ equity

Income Statement

Contains information on the profitability of the firm during some period of time

Indicates the flow of sales, expenses, and earnings during the time period

Statement of Cash Flows

Integrates the information on the balance sheet and income statementShows the effects on the firm’s cash flow of income statement items and changes in various items on the balance sheetThree sections show cash flows from Operating activities Investing activities Financing activities

Alternative Measures of Cash Flow

Cash flow from operations Traditional cash flow equals net income plus

depreciation expense and deferred taxes Also adjust for changes in operating assets and

liabilities that use or provide cash

Free cash flow recognizes that some investing and financing activities are critical to ongoing success of the firm Modifies cash flow from operations to reflect

necessary capital expenditures and projected divestitures

Purpose of Financial Statement Analysis

Evaluate management performance inProfitabilityEfficiencyRisk

Although financial statement information is historical, it is used to project future performance

Analysis of Financial Ratios

Ratios can often be more informative that raw numbersPuts numbers in perspective with other

numbersHelps control for different sizes of firms

Ratios provide meaningful relationships between individual values in the financial statements

Importance of Relative Financial Ratios

In order to make sense of a ratio, we must compare it with some appropriate benchmark or benchmarks

Examine a firm’s performance relative to: The aggregate economy Its industry or industries Its major competitors within the industry Its own past performance (time-series analysis)

Comparing to the Industry Norms

Most popular comparison

Industries affect the firms within them differently, but the relationship is always significant

The industry effect is strongest for industries with homogenous products

Can also examine the industry’s performance relative to aggregate economic activity

Comparing to the Firm’s Major Competitors

Industry averages may not be representative

A firm may operate in several distinct industries

Several approaches: Select a subset of competitors for the comparison

group Construct a composite industry average from the

different industries in which the firm operates

Comparing to the Firm’s Own Past Performance

Determine whether it is progressing or declining

Helpful for estimating future performance

Consider trends as well as averages over time

Five Categories of Financial Ratios

1. Common size statements2. Internal liquidity (solvency)3. Operating performance

Operating efficiency Operating profitability

4. Risk analysis Business risk Financial risk External liquidity risk

5. Growth analysis

Common Size Statements

Normalize balance sheets and income statement items to allow easier comparison of different size firms

A common size balance sheet expresses accounts as a percentage of total assets

A common size income statement expresses all items as a percentage of sales

Evaluating Internal Liquidity

Internal liquidity (solvency) ratios indicate the ability to meet future short-term financial obligationsCurrent Ratio examines current assets and current liabilitiesQuick Ratio adjusts current assets by removing less liquid assetsCash ratio relates cash (ultimate liquid asset) to current liabilities

Evaluating Internal Liquidity

Receivables turnover examines the management of accounts receivableInventory turnover relates inventory to sales or cost of goods sold (CGS)Cash conversion cycle is a good overall measure of liquidity and indicates the net delay between cash inflow and cash outflow

Evaluating Operating Performance

Operating efficiency ratios Examine how management uses its assets to generate

sales; considers the relationship between various asset categories and sales

Total asset turnover ratio indicates the effectiveness of a firm’s use of its total asset base to produce salesNet fixed asset turnover reflects utilization of fixed assets. This number can look temporarily bad if the firm has recently added greatly to its capacity in anticipation of future sales

Operating Profitability Ratios

Operating profitability ratios measureThe rate of profit on sales (profit margin)The percentage return on capitalExamine how management is doing at

controlling costs so that a large proportion of the sales dollar is converted into profit

Gross profit margin measures the rate of return after cost of goods sold

Operating Profitability Ratios

Operating profit margin measures the rate of profit on sales after operating expenses Operating profit is sometimes called Earnings

before interest and taxes (EBIT)

Net profit margin relates net income to sales

Since Net Sales is in the denominator of all of the three previous ratios, the common size income statement gives all of these ratios at once

Operating Profitability Ratios

Return on total capital relates the firm’s earnings to all capital invested in the businessReturn on owner’s equity (ROE) indicates the rate of return earned on the capital provided by the stockholders after paying for all other capital usedThe DuPont System divides ROE into several ratios that collectively equal ROE while individually providing insight

Operating Profitability Ratios

An extended DuPont System provides additional insights into ROEThe extended DuPont System shows that there are five components of return on equity (ROE):1. Operating profit margin2. Total asset turnover3. Interest expense rate4. Financial leverage multiplier5. Tax retention rate

Risk Analysis

Risk analysis examines the uncertainty of income for the firm and for an investorTotal firm risks can be decomposed into two basic sources: Business risk: The uncertainty in a firm’s operating

income, highly influenced by industry factors Financial risk: The added uncertainty in a firm’s net

income resulting from a firm’s financing decisions (primarily through employing leverage).

External liquidity analysis considers another aspect of risk from an investor’s perspective

Business Risk

Variability of the firm’s operating income over timeCan be measured by calculating the standard deviation of operating income over time or the coefficient of variationIn addition to measuring business risk, we want to explain its determining factors.

Business Risk

Two primary determinants of business riskSales variability The main determinant of earnings variability

Cost Variability and Operating leverage Production has fixed and variable costs Greater fixed production costs cause greater profit

volatility with changes in sales Fixed costs represent operating leverage Greater operating leverage is good when sales are

high and increasing, but bad when sales fall

Financial Risk

Interest payments are deducted before we get to net income These are fixed obligations

Similar to fixed production costs, these lead to larger earnings during good times, and lower earnings during a business decline Fixed financing costs are called financial leverage

The use of debt financing increases financial risk and possibility of default while increasing profitability when sales are high

Financial Risk

Two sets of financial ratios help measure financial risk Balance sheet ratios Earnings or cash flow available to pay fixed

financial charges

Acceptable levels of financial risk depend on business risk A firm with considerable business risk should likely

avoid lots of debt financing

Financial Risk

Proportion of debt (balance sheet) ratiosLong-term debt can be related to: Equity (L-t D/Equity)

How much debt does the firm employ in relation to its use of equity?

Total Capital [L-t D/(L-t D +Equity)] How much debt does the firm employ in relation to all

long-term sources of funds?

Total debt can be related to: Total Capital [Total Debt/(Ttl. Liab.–Non-int. Liab.)]

Assessment of overall debt load, including short-term

Financial Risk

Earnings or Cash Flow RatiosRelate operating income (EBIT) to fixed

payments required from debt obligationsHigher ratio means lower risk

Interest Coverage or Times Interest Earned Ratio May also want to calculated coverage ratios that reflect other fixed charges

Financial Risk

Cash flow ratios Fixed financing costs such as interest payments

must be paid in cash, so these ratios use cash flow rather than EBIT to assess the ability to meet these obligations

Relate the flow of cash available from operations to:

Interest expense Total fixed charges The face value of outstanding debt

External Liquidity Risk

Market Liquidity is the ability to buy or sell an asset quickly with little price change from a prior transaction assuming no new information

External market liquidity is a source of risk to investors

Analysis of GrowthGrowth Rates can be calculated for balance sheet accounts and for income statement itemsSustainable growth potential can be analyzed Important to both creditors and owners

Creditors interested in ability to pay future obligations For owners, the value of a firm depends on its future

growth in earnings, cash flow, and dividends g = ROE x Retention rate

The retention rate is one minus the firm’s dividend payout ratio

Anything that impacts ROE (profitability, asset management, and leverage) would also be a determinant of future growth

Analysis of Non-U.S. Financial Statements

Statement formats will be different

Differences in accounting principles

Ratio analysis will reflect local accounting practices

The Quality of Financial Statements

“Quality financial statements” reflect reality rather than use accounting tricks or one-time adjustments to make things look better than they are

High-quality balance sheets typically have Conservative use of debt Assets with market value greater than book No liabilities off the balance sheet

The Quality of Financial Statements

High-quality income statements Reflect repeatable earnings

Gains from nonrecurring items should be ignored when examining earnings

High-quality earnings result from the use of conservative accounting principles that do not overstate revenues or understate costs

The Value of Financial Statement Analysis

Financial statements, by their nature, are backward-looking

An efficient market will have already incorporated these past results into security prices, so why analyze the statements? Analysis provides knowledge of a firm’s operating

and financial structure This aids in estimating future returns

Uses of Financial Ratios

Stock valuation

Identification of corporate variables affecting a stock’s systematic risk (beta)

Assigning credit quality ratings on bonds

Predicting insolvency (bankruptcy) of firms

Financial Ratios and Stock Valuation Models

Stock valuation often considers discounted cash flow analysis Estimate cash flows Estimate an appropriate discount rate

A number of financial ratios can be useful in arriving at estimates for each of these inputs

Price ratio analysis for a stock Sometimes we estimate the value of a stock

through various price ratios such as P/E Would need to estimate variables such as expected

growth rate of earnings and dividends

Financial Ratios and Systematic Risk

A firm’s systematic risk (as measured by beta) is related to a number of financial statement variables

Financial Ratios and Bond Ratings

Changes in bond ratings are linked to changes in various financial statement variablesPredicting such changes in ratings before

they occur can increase the return on a bond or stock portfolio

Financial Ratios and Insolvency (Bankruptcy)Certainly, analysts and investors are concerned with the possibility of bankruptcyA number of variables have a rather strong

relationship to the bankruptcy experience of firms in the past

Can use financial statement analysis to identify firms where insolvency is a likely outcomes

Limitations of Financial Ratios

Always consider relative financial ratiosAccounting treatments may vary among firms, especially among non-U.S. firmsFirms may have have divisions operating in different industries making it difficult to derive industry ratiosAre the results consistent?Ratios outside an industry range may be cause for concern