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Transcript of Essentials of Financial Statement Analysis Revsine/Collins/Johnson/Mittelstaedt: Chapter 5 Copyright...
Essentials of Financial Statement
Analysis
Revsine/Collins/Johnson/Mittelstaedt: Chapter 5
Copyright © 2009 by The McGraw-Hill Companies, All Rights Reserved.McGraw-Hill/Irwin
2RCJM: Chapter 5 © 2009
Learning objectives
1. How competitive forces and business strategies affect firms’ financial statements.
2. Why analysts worry about accounting quality.
3. How return on assets (ROA) is used to evaluate profitability.
4. How ROA and financial leverage combine to determine a firm’s return on equity (ROE).
5. How short-term liquidity risk and long-term solvency risk are assessed.
6. How to use the Statement of Cash Flows to assess credit and risk.
3RCJM: Chapter 5 © 2009
Financial statement analysis:Tools and approaches
Tools: Approaches used with each tool:
1. Time-series analysis: the same firm over time (e.g., Wal-Mart in 2005 and 2006)
Common size statements
Trend statements
Financial ratios(e.g., ROA and ROE)
2. Cross-sectional analysis: different firms at a single point in time (e.g., Wal-Mart and Target in 2005).
3. Benchmark comparison: using industry norms or predetermined standards.
4RCJM: Chapter 5 © 2009
Evaluating accounting “quality”
Analysts use financial statement information to “get behind the numbers”.
However, financial statements do not always provide a complete and faithful picture of a company’s activities and condition.
5RCJM: Chapter 5 © 2009
How the financial accounting “filter” sometimes works
GAAP puts capital leases on the balance sheet, but operating leases are “off-balance-sheet”.
Managers have some discretion over estimates such as “bad debt expense”.
Managers have some discretion over the timing of business transactions such as when to buy advertising.
Managers can choose any of several different inventory accounting methods.
6RCJM: Chapter 5 © 2009
Financial ratios and profitability analysis
Return on assets
Asset turnover
Operating profit margin
Analysts do not always use the reported earnings, sales and asset figures. Instead, theyoften consider three types of adjustments to the reported numbers:
1. Remove non-operating and nonrecurring items to isolate sustainable operating profits.
2. Eliminate after-tax interest expense to avoid financial structure distortions.
3. Eliminate any accounting quality distortions (e.g., off-balance operating leases).
ROA= EBI
Average assets
EBI Sales
Sales Average assets
X
7RCJM: Chapter 5 © 2009
How can ROA be increased?
There are just two ways:
1. Increase the operating profit margin, or
2. Increase the intensity of asset utilization (turnover rate). Asset turnover
Operating profit margin
ROA=EBI
Average assets EBI
Sales Sales
Average assets
8RCJM: Chapter 5 © 2009
ROA and competitive advantage:Four hypothetical restaurant firms
Competition works to drive down ROA toward the competitive floor.
Companies that consistently earn an ROA above the floor are said to have a competitive advantage.
However, a high ROA attracts more competition which can lead to an erosion of profitability and advantage.
Firm A and B earn the same ROA, but Firm A follows a differentiation strategy while Firm B is a low cost leader.
Differences in business strategies give rise to economic differences that are reflected in differences in operating margin, asset utilization, and profitability (ROA).
Competitive ROA floor
9RCJM: Chapter 5 © 2009
Credit risk and capital structure:Overview
Credit risk refers to the risk of default by the borrower.
The lender risks losing interest payments and loan principal.
A company’s ability to repay debt is determined by it’s capacity to generate cash from operations, asset sales, or external financial markets in excess of its cash needs.
A company’s willingness to repay debt depends on which of the competing cash needs management believes is most pressing at the moment.
10RCJM: Chapter 5 © 2009
Credit risk and capital structure:Balancing cash sources and needs
11RCJM: Chapter 5 © 2009
Credit risk:Short-term liquidity ratios
Short-termliquidity
Activityratios
Liquidityratios
Current ratio =Current assets
Current liabilities
Quick ratio =Cash + Marketable securities + Receivables
Current liabilities
Accounts receivable turnover =Net credit sales
Average accounts receivable
Inventory turnover =Cost of goods sold
Average inventory
Accounts payable turnover =Inventory purchases
Average accounts payable
12RCJM: Chapter 5 © 2009
Credit risk:Long-term solvency
Long-termsolvency
Coverageratios
Debt ratios
Long-term debt to assets =Long-term debt
Total assets
Long-term debt to tangible assets =Long-term debt
Total tangible assets
Interest coverage =Operating incomes before taxes and interest
Interest expense
Operating cash flow to total liabilities
Cash flow from continuing operations
Average current liabilities + long-term debt=
13RCJM: Chapter 5 © 2009
Components of ROCE
Return on commonequity (ROCE)
Return on assets (ROA)
Common earnings leverage
Financial structure leverage
Net income available to common shareholders
Average common shareholders’ equity
EBI
Average assets
Net income available to common shareholders
EBI
Average assets
Average common shareholders’ equity
X
X
14RCJM: Chapter 5 © 2009
Financial statement analysis and accounting quality
Financial ratios, common-size statements, and trend statements are extremely powerful tools.
But they can be no better than the data from which they are constructed.
Be on the lookout for accounting distortions when using these tools. Examples include:
Nonrecurring gains and losses
Differences in accounting methods
Differences in accounting estimates
GAAP implementation differences
Historical cost convention
15RCJM: Chapter 5 © 2009
Why do firms report EBITDA and “pro forma” earnings?
Impression management is the answer.
Help investors and analysts spot non-recurring or non-cash revenue and expense items that might otherwise be overlooked.
Mislead investors and analysts by changing the way in which profits are measured.
Transform a GAAP loss into a profit.
Show a profit improvement. Meet or beat analysts’ earnings
forecasts.
Analysts should remember:
1. There are no standard definitions for non-GAAP earnings numbers.
2. Non-GAAP earnings ignore some real business costs and thus provide an incomplete picture of company profitability.
3. EBITDA and pro forma earnings do not accurately measure firm cash flows.
16RCJM: Chapter 5 © 2009
Summary
Financial ratios, common-size statements and trend statements are powerful tools.
However: There is no single “correct” way to compute financial ratios.
Financial ratios don’t provide the answers, but they can help you ask the right questions.
Watch out for accounting distortions that can complicate your interpretation of financial ratios and other comparisons.