Financial Statement Analysis Chapter 19 Financial Statement Analysis Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 19-1

Overview Purpose Tools Used Limitations Statements Ratio Analysis 19-2 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 19-2

Financial Statements Balance Sheet Income Statement Common Sized Trend or Indexed Income Statement Statement of Cash Flows Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 19-3

Statement of Cash Flows Unlike income statement: Cash is King Ignores non-cash items i.e. depreciation Doesn’t distinguish between nature of outflows Reveals well-being of a firm More concern with liquidity Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 19-4

Accounting Earnings Accounting Earnings Reported net income convey information: Reliability LIFO approach FIFO approach Method of depreciation Valuation of inventories Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 19-5

Ratio Analysis Purpose of Ratio Analysis Uses Combination Trend analysis Comparative analysis Combination Use by External Analysts Important information for investment community Important for credit markets Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 19-6

Type of Financial Ratios Liquidity Ratios Activity or Management Efficiency Ratios Leverage Ratios Profitability Ratios Market Price Ratios Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 19-7

Liquidity Ratios Current Ratio Current Assets Current Liabilities Quick Ratio Current Assets - Inventory Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 19-8

Liquidity Ratios Interest coverage ratio: Can we pay interest from our earnings? EBIT/Interest expenses Times interest earned Determines firm’s debt capacity Higher is better Handy for lenders Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 19-9

Activity or Management Efficiency Ratios Inventory Turnover Sales or Cost of Goods Sold Inventory Total Asset Turnover Sales Total Assets Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 19-10

Activity or Management Efficiency Ratios Average Collection Period Accounts Receivable Sales Per Day Days to Sell Inventory Inventory Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 19-11

Leverage Ratios Times Interest Earned Earnings Before Int. & Taxes Interest Expense Fixed Charge Coverage Ratios Lease Payments Principal Repayments Preferred Dividends Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 19-12

Leverage Ratios Debt to Assets Long Term Debt Assets Debt to Equity Shareholders Equity Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 19-13

Profitability Ratios Net Profit Margin % Net Income Sales Return on Assets Total Assets Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 19-14

Profitability Ratios Return on Equity Net Income Common Equity Operating Margin After Depr. Operating Profit Sales Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 19-15

Past versus Future ROE Will future ROE approximate its past value? High ROE doesn’t give guarantee for similar ROE in future Don’t accept history blindly Expectation of dividends Expectation of earnings Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 19-16

Market Price Ratios Price to Earnings Market Price of Stock Earnings Market-to-Book-Value Book Value Per Share Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 19-17

Decomposition of ROE Net Profit Pretax Profit Pretax Profit EBIT EBIT Sales Sales Assets Assets Equity ROE = x x x x (1) x (2) x (3) x (4) x (5) Tax Burden Interest Burden x x Margin x Turnover x Leverage Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 19-18

Decomposition of ROE Du Pont System Decomposing into a series of ratios Each part is complete in itself Product makes the difference Meaningful for comparison Both time-series and cross-section comparison Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 19-19

Choosing a Benchmark Is the ratio good or bad? Don’t know Compare it With other firms in the same industry Over the time period (Time series) Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 19-20

Economic Value Added Difference between return on assets (ROA) and the opportunity cost of capital (k) EVA = above difference time the invested capital EVA can be positive or negative for firms that have positive earnings Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 19-21

Quality of Earnings Reported earnings Evaluation of quality of earnings Any window dressing All that glitters is not gold Conservatism concept Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 19-22

Quality of Earnings Factors influencing quality of earnings: Bad debts allowances Non-recurring items Stock options Revenue recognition Off-Balance sheet Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 19-23

Comparability Problems Accounting Differences Inventory Valuation Depreciation Inflation International Accounting Conventions Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 19-24

Inventory Valuation Common ways to value inventory: LIFO FIFO LIFO is preferred over FIFO in calculating economic earnings (Up-to-date prices) LIFO induces balance-sheet distortions Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 19-25

Depreciation Economic definition Accounting definition Different methods Different for tax than for reporting Problematic during inflationary period Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 19-26

International Accounting Differences Reserves – many other countries allow more flexibility in use of reserves Depreciation – US allows separate tax and reporting presentations Intangibles – treatment varies widely Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 19-27

Adjusted vs. Reported Price-Earnings Ratios Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 19-28

Summary Superiority of real economic earnings ROE and growth rate of earnings Decomposition of ROE Fixed asset turnover ratio Inventory turnover ratio Days receivable Current and quick ratio Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 19-29

Summary Market-to-book value ratio Price-to-earning ratio Higher ROE and overpriced stocks Issue of comparability Comparability during high inflation period Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 19-30