Financial Statement Analysis Financial Rations

Financial Statement AnalysisFinancial Rations

Marcel Rindisbacher

September 18, 2001

MGT337: Business Finance

Objectives: Financial Statements Analysis

Have argued that an appropriate goal of the firm is to maximize shareholdervalue. Before we introduce fundamental valuation principles we give a quickoverview over the diagnostic tools used to analyze corporations.

Financial Statement Analysis:

• Where do we find relevant financial information about a firm ?

• How do we measure the performance of a firm?

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Financial Statement Analysis

What are the basic sources of information for valuation ?

• balance sheet: Lists assets, debt and equity.

• income statement: Shows changes in net worth over period.

• statements of changes in financial conditions: shows changes in financialpositions. Different statements:

– sources and uses of working capital– sources and uses of cash– cash vs. working capital from operations

Remark: All three statements must appear in annual report of the corporation

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Additional Sources of Information

• Prospectus (issue of new securities)

• Quarterly shareholder reports

• Press releases

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Balance Sheet

Informational content: Lists assets, liabilities and shareholder’s equity fromaccounting point of view: Assets=Liabilities+Equity.

Shortcoming for valuation of firm: Contains accounting values according togenerally accepted accounting principles (GAAP),not economic values. ⇒ historicalpoint of view of accounting is not always appropriate for valuation of a firm.

Examples:

• Book and market value of the firm do not coincide.

• Exclusion of intangible assets of firm ⇐ Lack of objective valuation principles.(patents, copyrights, brand names etc.)

• Exclusion of liabilities on the balance sheet ⇐ Lack of objective valuationprinciples. (Example: liabilities from potential environmental clean-up of achemical company).

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Income Statement

Informational content: Shows changes in accounting income (earnings orprofits) : Changes in net worth (Assets - Liabilities).

Shortcomings for valuation of firm:

• Value of firm depends on cash flows not earnings. Earnings differ from cash flowssince books of firm are on accrual not cash basis. (Example: Sales revenues arerecorded when goods are sold not when cash is collected)

• Accounting income differs from economic income (changes in net wealth duringa period). ⇐ economic income depends on future cash flows associated withfirms’ assets and liabilities. (Sales forecasts, R & D expenditures and advertisingexpenditures).

• Replacement cost of inventories (FIFO, LIFO).

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Statements of Changes in Financial Position

Informational Content: The sources and uses of funds statements attempts toaccount for the sources and using of funds.

Remark: Comes closest to measure cash flows ⇒ Important for financialmanagment.

Different Statements:

1. Sources and use of working capital statements: Reports firms liquidity.

2. Sources of uses of cash: Reports (a) how much cash did the firm generate duringthe accounting period ? (b) where did the cash come from ? What did the firmdo with its cash ?

3. Cash vs. working capital from operations: Reports changes in cash fromoperations.

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Financial Ratio Analysis

Objective: Diagnostic tool to evaluate financial condition of the firm

(a) comparison over time

(b) comparison with industry averages.

Warning : Financial ratios should only be interpreted in the context of businessstrategy !

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Categories of Financial Ratios

Liquidity ratios: How likely is critical gap in short-term cash in- and outflows ?

Activity ratios: How efficient does firm operate ?

Leverage ratios: How likely is default ?

Profitability ratios: How efficient are managers ?

Market value ratios: How does market evaluate company performance ?

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Liquidity ratios

• Current ratio: = Current assets / Current liabilities

• Quick ratio := (Current assets -Inventories)/ Current liabilities

Remark: Inventories are least liquid current asset ⇒ Current ratio moreconservative indicator of liquidity than quick ratio.

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Activity ratios

• Accounts receivable turnover := Net credit sales / receivables

Remark: a low accounts receivable turnover means that firm manages itsreceivables well. Alternatively, could measure the average collection periodof receivables.

• Inventory turnover := Cost of goods sold / inventory

Remark: a high inventory turnover indicates that inventories are moving fastthrough the company and therefore generate sales quickly.

• Fixed asset turnover := Net sales / net fixed assets

Remark: a high fixed assets turnover means that fixed assets generate a highrevenue. (Important: sensible to depreciation policy).

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• Total asset turnover := Net sales / average total assets

Remark: a high asset turnover indicates efficient management.

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Financial Leverage Ratios

• Debt ratio := Total liabilities / total assets

Remark: a high debt ratio indicates that default is more likely.

• Debt equity ratio := Total liabilities / total equity

Remark: a high debt equity ratio means that shareholder’s stakes are at risk.

• Interest coverage (Time interest earned) := EBIT / Annual interest expenses

Remark: a high time interest earned means that firm has higher capacity to meetits interest payments out of its operating earnings.

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Profitability Ratios

• Gross profit margin := Gross profit / net sales

Remark: a high gross profit margin indicates either low costs and/or highmark-ups. (depends on elasticity of demand).

• Operating profit margin := EBIT / net sales

Remark: a high operating profit margin measures profitability of company runningits operations.

• Net profit margin := Net income / net sales

Remark: like gross profit margin, but corrects for tax effects.

• Return on total asset := Net income / total assets

Remark: Also known as return on investments. a low return on investment canindicates low net revenues.

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• Net profit margin := Net income / Net sales

Remark: a low net profit margin indicates that the firms operations havedifficulties to meet the company’s financial liabilities.

• Return on total assets := Net income / total assets

Remark: difficulties to measure income and assets

• Return on net assets := EBIT(1-Tax rate)/(Debt + Equity)

Remark: important for comparison of firms.

• Return on equity := Net income / Shareholder’s equity

Remark: a high return on equity indicates an efficient management.

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Market Value Ratios

• Price-earnings ratio := Market price per share / earnings per share

Remark: a high price-earning ratio reflects market perception of firm’s growthand profit opportunities, but is also affected by changes in the risk-free rate andeconomic growth conditions.

• Market-to-book ratio := Market price per share / book value per share

Remark: a high market-to-book value means that company creates a high netpresent value.

• Tobin’s q := (Market value of debt + equity)/ replacement cost of assets

Remark: like market-to-book value put uses replacement costs instead of bookvalue to correct problems caused by inflation.

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Financial Statement Analysis Financial Rations

Economy & Finance

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