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Transcript of ANALYSIS OF FINANCIAL STATEMENTS. Analyzing Financial Statements We will be considering asset...
ANALYSIS OF FINANCIAL STATEMENTS
Analyzing Financial Statements
We will be considering asset valuation.Financial asset values are a function of two variables:Discount rate ( the required rate of return)Expected future cash flows
Financial statement analysis can be useful in estimating both of these valuation inputs.
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 resourcesIndicates current and fixed assets available at a point in timeFinancing 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 Aggregate Economy
Most firms are influenced by economic expansions and contractions in the business cycle
Analysis helps you estimate the future performance of the firm during subsequent business cycles
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
Six 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 obligations
Current Ratio examines current assets and current liabilities
sLiabilitieCurrent
AssetsCurrent RatioCurrent
Evaluating Internal Liquidity
Quick Ratio adjusts current assets by removing less liquid assets
sLiabilitieCurrent
sReceivableSecurities MarketableCashRatioQuick
Evaluating Internal Liquidity
Cash ratio relates cash (ultimate liquid asset) to current liabilities
sLiabilitieCurrent
Securities MarketableCashRatioCash
Evaluating Internal Liquidity
Receivables turnover examines the management of accounts receivable
sReceivable Average
Sales AnnualNet Turnover sReceivable
Receivables turnover can be converted into an average collection period
Turnover Annual
365Period Collection sReceivable Average
Evaluating Internal Liquidity
Inventory turnover relates inventory to sales or cost of goods sold (CGS)
Inventory Average
Sold Goods ofCost TurnoverInventory
Given the turnover values, you can compute the average inventory processing time
Turnover Annual
365Period ProcessingInvetory Average
Evaluating Internal Liquidity
Cash conversion cycle combines information from the receivables turnover, inventory turnover, and accounts payable turnover
CCC = Receivables Collection Period + Inventory Processing Period - Payables Payment Period
Evaluating Operating Performance
Ratios that measure how well management is operating a businessOperating efficiency ratios
Examine how management uses its assets to generate sales; considers the relationship between various asset categories and sales
Operating profitability ratiosExamine how management is doing at
controlling costs so that a large proportion of the sales dollar is converted into profit
Operating Efficiency Ratios
Total asset turnover ratio indicates the effectiveness of a firm’s use of its total asset base to produce sales
AssetsNet Total Average
SalesNet TurnoverAsset Total
Operating Efficiency Ratios
Net 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
Assets FixedNet Average
SalesNet TurnoverAsset Fixed
Operating Profitability Ratios
Operating profitability ratios measure The rate of profit on
sales (profit margin) The percentage
return on capital
Operating Profitability Ratios
Gross profit margin measures the rate of return after cost of goods sold
What proportion of the sales dollar is left after cost of goods sold? Is the firm buying inputs (inventory and
direct labor) at good prices?
SalesNet
Profit GrossMarginProfit Gross
Operating Profitability Ratios
Operating profit margin measures the rate of profit on sales after operating expensesOperating profit is sometimes called
Earnings before interest and taxes (EBIT)Operating income can be thought of as the
“bottom line” from operations
SalesNet
Profit OperatingMarginProfit Operating
Operating Profitability Ratios
Net profit margin relates net income to salesShows the combined effect of operating
profitability and the firm’s financing decisions (since net income is after interest and tax payments)
SalesNet
IncomeNet MarginProfit Net
Common Size Income Statement
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 It also allows us to focus on any categories
of expenses that are out of line with the appropriate benchmark
Operating Profitability Ratios
Return on total capital relates the firm’s earnings to all capital invested in the business
Capital Total Average
ExpenseInterest IncomeNet Capital Totalon Return
Operating Profitability Ratios
Return on owner’s equity (ROE) indicates the rate of return earned on the capital provided by the stockholders after paying for all other capital used
Equity Total Average
IncomeNet Equity Totalon Return
Operating Profitability Ratios
Return on owner’s equity (ROE) can be computed for the based only on the common shareholder’s equityDeducts preferred dividends, which are a
priority claim on net income
EquityCommon Average
Dividend Preferred-IncomeNet Equity sOwner'on Return
Operating Profitability Ratios
The DuPont System divides ROE into several ratios that collectively equal ROE while individually providing insight
EquityCommon
SalesNet
SalesNet
IncomeNet
EquityCommon
IncomeNet ROE
Equity
Assets Total
Assets Total
Sales
Equity
Sales
Operating Profitability Ratios
EquityCommon
Assets Total
Assets Total
Sales
Sales
IncomeNet
EquityCommon
IncomeNet
Profit Total Asset Financial
Margin Turnover Leverage= xx
Operating Profitability Ratios
An extended DuPont System provides additional insights into the effect of financial leverage on the firm and pinpoints the effect of income taxes on ROE
We begin with the operating profit margin (EBIT divided by sales) and introduce additional ratios to derive an ROE value
Operating Profitability Ratios
Assets Total
EBIT
Assets Total
Sales
Sales
EBIT
This is the operating profit return on total assets. To consider the negative effects of financial leverage, we examine the effect of interest expense as a percentage of total assets
Operating Profitability Ratios
Assets Total
EBIT
Assets Total
Sales
Sales
EBIT
Assets Total
Tax BeforeNet
Assets Total
ExpenseInterest
Assets Total
EBIT
We consider the positive effect of financial leverage with the financial leverage multiplier
Operating Profitability Ratios
Assets Total
EBIT
Assets Total
Sales
Sales
EBIT
Assets Total
Tax BeforeNet
Assets Total
ExpenseInterest
Assets Total
EBIT
EquityCommon
(NBT)Tax BeforeNet
EquityCommon
Assets Total
Assets Total
(NBT)Tax BeforeNet
This indicates the pretax return on equity. To arrive at ROE we must consider the tax rate effect.
Operating Profitability Ratios
Assets Total
EBIT
Assets Total
Sales
Sales
EBIT
Assets Total
Tax BeforeNet
Assets Total
ExpenseInterest
Assets Total
EBIT
EquityCommon
(NBT)Tax BeforeNet
EquityCommon
Assets Total
Assets Total
(NBT)Tax BeforeNet
EquityCommon
IncomeNet
Tax BeforeNet
Taxes Income%100
EquityCommon
Tax BeforeNet
Operating Profitability Ratios
In summary, we have the following five components of return on equity (ROE):
1. Operating profit margin
2. Total asset turnover
3. Interest expense rate
4. Financial leverage multiplier
5. 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
Financial Risk
Interest Coverage or Times Interest Earned Ratio Measures the number of times Interest
payments are “covered” by EBIT
Interest Coverage = EBIT/Interest Expense
May also want to calculated coverage ratios that reflect other fixed chargesLease obligations (Fixed charge coverage)
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
External Liquidity Risk
The most important factor of external market liquidity is the dollar value of shares tradedThis can be estimated from the total
market value of outstanding securities It will be affected by the number of security
ownersNumerous buyers and sellers provide liquidity
Analysis of Growth Potential
Want to determine sustainable growth potential 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
Determinants of Growth
Sustainable Growth Model Suggests that the sustainable growth rate is a
function of two variables: What is the rate of return on equity (which gives the
maximum possible growth)? How much of that growth is put to work through earnings
retention (rather than being paid out in dividends)? g = ROE x Retention rate
The retention rate is one minus the firm’s dividend payout ratio
Anything that impacts ROE would also be a determinant of future growth
Determinants of Growth
ROE (recall the DuPont equation) is a function ofNet profit marginTotal asset turnoverFinancial leverage (total assets/equity)
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
The Quality of Financial Statements
High-quality balance sheets typically have Conservative use of debtAssets with market value greater than bookNo 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