Principles of Investing FIN 330 Chapter 8 Financial Statement Analysis Dr. David P Echevarria All Rights Reserved

Review of Financial Statements Balance Sheet Snapshot of company’s assets, Liabilities and Equity at end of fiscal year Income statement Sales, expenses, and taxes incurred to operate Earnings per share: Net Income / # Shares Out. Cash flow statement Sources and uses of funds Are financial statements reliable? G.A.A.P. vs Cleverly Rigged Accounting Ploys Principal motive for Sarbanes-Oxley (2002) Dr. David P Echevarria All Rights Reserved

Sources of Information Financial Statement Data Quarterly, Annual Reports issued by companies to stockholders Computerized Data Bases such as Compustat (WRDS) Standard & Poor' Industrial Manuals, Moody's EDGAR database at the SEC (www.edgar.sec.org) Industry Averages Robert Morris Associates Dun & Bradstreet Federal Agencies; Commerce Department Federal Reserve Dr. David P Echevarria All Rights Reserved

Ratio Categories Liquidity ratios Measure ability to pay maturing obligations Current ratio Current assets / current liabilities Quick ratio Current assets less inventories / current liabilities Cash ratio (Cash + M/S)  current liabilities Defensive Interval = [(Cash + M/S + A/R) * 365 ]  (COGS + SGA). Dr. David P Echevarria All Rights Reserved

Ratio Categories B. Asset Management [Activity] ratios Measure effectiveness of asset management Days Sales Outstanding (DSO) Average receivables / Sales per day Inventory turnover (times per year) Cost of Goods Sold / average inventory Total asset turnover Sales / average total assets Fixed asset turnover Sales / average net fixed assets Dr. David P Echevarria All Rights Reserved

Ratio Categories C. Debt Management [Leverage] ratios Measure extent to which firm uses debt to finance asset investment (risk attribute) Debt-equity ratio Total long-term debt / total equity Total debt to total assets ratio (Debt Ratio) Current liabilities + long-term debt / total assets Times interest earned EBIT / interest charges Fixed charge coverage ratio (EBIT + Lease Exp.) / (Int. Exp. + Lease Exp.) Dr. David P Echevarria All Rights Reserved

Ratio Categories D. Profitability ratios Gross profit margin (%) Gross profit / sales Operating Profit Margin (%) Operating profits / sales (Sales - COGS - operating expenses) / sales Net profit margin (%) Net profit after taxes / sales Return on total capital (%) Net income + interest expense / Total long-term capital Return on stockholders’ equity (ROE) (%) Net income after taxes / common stock equity Dr. David P Echevarria All Rights Reserved

Ratio Categories Valuation Ratios Price / Earnings: Price / EPS Book Value: Total Assets –Total Liabilities TA – TL = [Total Common] Equity Book Value Per Share = BV / # Shares Out. Earnings per Share = Net Income / # Shares Out Dr. David P Echevarria All Rights Reserved

DuPont System ROE = ROA * Equity Multiplier Objective of DuPont System ROA = Net Income / Total Assets Equity Multiplier = Total Assets / Common Equity Objective of DuPont System Assist management in identifying areas where performance can be improved. It also helps to understand the impact of changes in the debt ratio on ROE – which in turn affects stock price. Dr. David P Echevarria All Rights Reserved

Estimating Earnings and Fair Market Value for Equity Six Steps (Review) Estimate next year’s sales revenues Estimate next year’s expenses Earnings = Revenue - Expenses Estimate next year’s dividend per share = Earnings Per Share * dividend payout ratio Estimate the fair market value of stock given next years earnings, dividend, ROE, and growth rate for dividends Using Gordon Growth model or P/E Model Dr. David P Echevarria All Rights Reserved

Estimating Earnings and Fair Market Value for Equity Implications for investors Fundamental analysis assumes company performance and stock performance are correlated Forecasting EPS and P/E helps predict expected returns Remember: The market is always and everywhere an expectations phenomenon – We Buy the future not the past. Dr. David P Echevarria All Rights Reserved

Homework Discussion Questions: 4, 7, 8, 10, 12 Problems: 1, 10, 15 (parts a thru e) Dr. David P Echevarria All Rights Reserved