fm chapter 4
TRANSCRIPT
Finance 311 1
Chapter 4 Evaluation of Financial Performance
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Introduction
This chapter introduces financial statement analysis techniques that are used to accurately evaluate a company’s performance. We will assume that the financial statements are fairly and accurately presented.
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Financial Ratios Are Used By
Management for planning and evaluating Credit managers and bankers to estimate
the riskiness of potential borrowers Investors to evaluate corporate securities Managers to identify and assess potential
merger candidates Widely used and accepted technique
Use started in the 1920s
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Ratio Analysis Many, many ratios
Choose the ones that are most relevant for you
Must be compared with a standard and also the past (three years, for example)
A financial ratio is only an indicator One can possibly manipulate ratios
Accounting differences in firms WorldCom (MCI), ENRON, HealthSouth,
Ahold, Tyco, etc.
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Ratio Classifications
Liquidity Asset management Financial leverage management Profitability Market-based Dividend policy
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Major Financial Statements
Balance sheet Common-sized balance sheet shows
assets, liabilities, and equity as a % of total assets
Income statement Common-sized income statement
shows income and expense items as a % of net sales
Statement of cash flows
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Common-Sized Statements
Publicly-owned firms must publish financial statements quarterly and annually
Widely used in banking and investments
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Liquidity Ratios Current ratio = Current assets Current liabilities
Quick ratio = Current assets - Inventories
Current liabilitiesAging Schedule for Accounts Receivable
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Asset Management Ratios
Average collection period = Accounts receivable
Annual credit sales/ 365 Inventory turnover = Cost of sales Average inventory Fixed-asset turnover = Sales Net fixed assets Total asset turnover = Sales Total assets
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Financial Leverage Management
Debt ratio = Total debt Total assets Debt-to-equity ratio = Total debt Total equity Times interest earned = EBIT Interest charges Fixed charge coverage = EBIT + Lease payments Interest + Lease payment +
P/S div before tax+ Before-tax sinking fund
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Profitability Ratios Gross profit margin = Sales - Cost of
sales Sales Net profit margin = EAT Sales ROI = EAT Total Assets ROE = EAT Stockholders equity
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Market-Based Ratios
P/E ratio = Market price per share Current earnings per share
Market to book ratio = Market price per share
Book value per shareStock Price/ Free Cash Flow
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Dividend Policy Ratios
Payout ratio = Dividends per share Earnings per share
Dividend yield = Expected dividends
per share Stock price
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Relationships Among Ratios
ROI = EAT x Sales = EAT Sales Total assets Total assets
ROE = EAT x Sales x Total assets Sales Total assets Equity
ROE = Net Profit Margin x Total Asset Turnover x Equity Multiplier
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Dupont Analysis Widely used in industry Shows impacts that operating
changes can have on returns
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Financial Ratio Analysis Trend analysis 2002 2003 2004 XYZ current ratio 1.9 2.2 2.3
Cross-sectional analysis 2004 XYZ current ratio 2.3 Industry norms 2.5
Both simultaneously 2002 2003 2004 XYZ current ratio 1.9 2.2 2.3 Industry norms 2.5 2.4 2.5
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Some Sources of Information
Trading Room (406 Sirrine Hall)
Bridge (Telerate) Bloomberg Reuters
General Business File of Cooper Library
Factiva Mergent Database TableBase Reuters Business Insight RMA Annual Statement
Studies Reserves on 2nd Floor
Visit Index Table 3 in Library
Annual reports 10K’s - SEC EDGAR
Corporate Database Standard and Poor’s Value Line Industry Norms and
Key Business Ratios The Internet
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A Few of the Sources of Information on the Web
http://www.bloomberg.com/ http://www.sec.gov/ http://finance.yahoo.com/ http://www.dnbcorp.com/ http://www.rmahq.org/ http://www.moodys.com/ http://www.hoovers.com/ But, please be careful. Remember you
get what you pay for…
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Quality of a firm’s earnings is positively related to the proportion of cash earnings to total earnings and to the proportion of recurring income to total income.Large non-cash component in the earningsSignificant non-recurring transactions in the income figure
Quality of a firm’s balance sheet is positively related to the ratio of the market value of the firm’s assets to book value of assets and inversely related to the amount of its hidden liabilities.Presence of obsolete inventories and charging off assetsHidden assets Assets have market values significantly below book values
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Problems in Reporting Time of revenue recognition Pension Fund Earnings Assumptions Amortization of intangible assets Including all losses and debt
Off-Balance-Sheet Financing - ENRON
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Ratios Can Be Misleading Differing accounting practices Might be significant dispersion in
the ratio for the industry Many firms operate in more than
one industry - Industry classification Financial ratios provide a historical
record of performance
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The Bridge System Turn on Monitor Log on Click on Telerate Double Click on the background Go to Analytics Page Type: /LU/Company for Ticker Symbol Type: the Ticker Symbol/CF
CF = Corporate Fundamentals Scroll through the Corporate Fundamentals Type: the Ticker Symbol[Beta
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To Obtain the Latest Corporate News
Tab to another page in Telerate Double click on the background Go to News Watch Right Click then Search by Ticker Symbol Type in the Ticker Symbol Then double click on any headline story to
bring up the entire story. You can print out the story or possibly save it to a
disk.
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Analysis Based on the Market Value of the
Firm Market value added ( MVA ) = Total
Market value – Total CapitalMVA is the market value of debt, preferred
stock, and common equity less the Capital raised by investors or Retained Earnings.
The capital market’s assessment of the accumulated NPV of all of the firm’s past and present projected investment projects.
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Economic Value Added (EVA)
Economic value added ( EVA ) = [ Return on total capital (r) – Cost of Capital (k )] x Capital
EVA = EBIT(1 – Corporate tax rate) – (Operating Capital)(k)
r = net operating profits after taxes divided by beginning of year capital (Return on Capital)
k = Weighted After-Tax Cost of Capital
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EVA - Continued
The yearly contribution of a firm’s operations to the creation of MVA.
EVA measures the extent to which the firm has increased shareholder value in a given year.
EVA represents the residual value that remains after the cost of all capital, including equity capital has been deducted.
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Increase Economic Value Added (EVA)
Increase operating efficiency Commit new resources that
promise a high return Redirect resources to more
productive uses Make prudent use of tax benefits
of debt financing
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Problems Caused by Inflation
Inventory profit as a result of timing of price increases
Inventory valuation methods ( LIFO ) ( FIFO ) Rising interest rates causes a decline in the
value of long term debt Differences in the reporting of earnings Understatement of fixed assets Recognition of sales
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The Cash Flow Concept
Accounting income Vs Cash flow Cash flow is the relevant source of value for
the firm ATCF = EAT + Noncash charges ATCF = EAT + Depreciation + Deferred taxes Free Cash Flow (FCF) = EBIT(1 – T) – Net
Investment in operating capital FCF = (EBIT(1 – T) + Depreciation) – Gross
investment in operating capital
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Statement of Cash Flows
Presents the net cash provided by operating, investing, or financing activities Direct method presents the net cash
provided by operating, investing, or financing activities
Indirect method presents the adjustments to net income to show net cash provided
Used for public financial reports The final results are identical
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Complex International Aspects of Financial Statement Analysis
Influenced by fluctuating exchange rates
SFAS No. 52 deals with foreign currency translation
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Accuracy of Financial Statements
External auditor Generally accepted accounting
principles People pose for a picture like a
corporation poses for a financial statement
Sarbanes-Oxley Act of 2002
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Conclusion Financial Statements
Balance Sheet Income Statement Statement of Cash
Flows Common-sized Sarbanes-Oxley Act
Ratios Liquidity Asset management Financial leverage
Profitability Market-based Dividend policy
DuPont Analysis Sources of
information Market Value
Added Economic Value
Added