FINANCIAL STATEMENT ANALYSIS CHAPTER 13

Fundamental Analysis Finance (chapter 12): Valuation techniques Dividend discount model, P/E ratio Need input as dividends and earnings prospects Economics (chapter 11) (information from outside) macro level: market micro level: industries, firms Accounting (chapter 13) (information from inside) How to read reported data? How to use financial data as inputs into stock valuation

Financial Statement Analysis Objectives: Use a firm’s income statement, balance sheet, and statement of cash flows to calculate standard financial ratios. Calculate the impact of taxes and leverage on a firm’s return on equity using ratio decomposition analysis. Measure a firm’s operating efficiency Identify likely sources of biases in accounting data.

Income Statement Firm’s revenues and expenses during a specific period Typical format Sale - Operating expense COGS Depreciation Operating Income (EBIT) - Interest Earning before tax (EBT) - Tax Net Income (NI)

Table 14.1 Consolidated Statement of Income

Balance Sheet A snapshot of firm’s assets and liability at a given point in time Asset Liabilities + Equity 1. Current Asset 1. Current liabilities Cash Short term debt Account receivable Account payable Inventory Note payable 2. Fixed asset 2. Long-term debt 3. Equity Common stock Retained earning Total assets Total liabilities + equity

Table 14.2 Consolidated Balance Sheet

Statement of cash flow Net income: accounting profit Cash flow: cash available on hand Statement of cash flow: firm’s cash receipts and payments during a specific period

Table 14.3 Consolidated Statement of Cash Flows

Return on Equity (ROE) ROE=Net profit/Equity g = ROE × b To estimate g, need to estimate ROE Past ROE might not be good estimator of future ROE ROE is linked with ROA and affected by firm’s financial policies Watch out financial leverage: ROA: Return on Assets=EBIT/Assets

Du Pont System: Decomposition of ROE Net Profit Pretax Profit x EBIT Sales Assets Equity (1) x (2) x (3) x (4) x (5) x Margin x Turnover x Leverage Tax Burden Interest x

Problem 7, Chapter 13, P. 456 An analyst applies the DuPont system of financial analysis to the following data for a company: Leverage ratio 2.2 Total asset turnover 2.0 Net profit margin 5.5% Dividend payout ratio 31.8% What is the company’s return on equity?

Ratio analyses Liquidity Ratios Activity or Mgmt Efficiency Ratios Leverage Ratios Profitability Ratios Market Price Ratios

2002 2003 2004 2005 Income statements Sale revenue 100,000 120,000 144,000 Cost of goods sold 55,000 66,000 79,200 Depreciation 15,000 18,000 21,600 Selling and administrative expenses 15,000 18,000 21,600 Operating income 30,000 36,000 43,200 Interest expense 10,500 19,095 34,391 Taxable income (40% tax rate) 7,800 6,762 3,524 Net Income 11,700 10,143 5,285 Balance Sheet (end of year) Cash and marketable securities 50,000 60,000 72,000 86,400 Account receivables 25,000 30,000 36,000 43,200 Inventories 75,000 90,000 108,000 129,600 Net plant and equipment 150,000 180,000 216,000 259,200 Total Asset 300,000 360,000 432,000 518,400 Account payable 30,000 36,000 43,200 51,840 Short-term debt 45,000 87,300 141,957 214,432 Long-term debt 75,000 75,000 75,000 75,000 Total Liabilities 150,000 198,300 260,157 341,272 Shareholders’equity (1 mil shares outstanding) 150,000 161,700 171,843 177,128 Market price per common share at year-end 93.60 61.00 21.00

Liquidity ratios Current ratio = Current asset/ current liabilities 2003 2004 2005 2005 industry average (IA) 1.46 1.17 0.97 2.0 Trend: decreasing poor standing relative to industry Quick ratio = (current asset-inventory)/current liability 2003: quick ratio = (60+30)/(36+87.3) = 0.73 0.73 0.58 0.49 1.0

Management efficient ratios Inventory turnover = COGS (excluding depreciation) / average inventory How fast firm can sell inventory 2003: inventory turnover = (55-15)/{(75+90)/2)}= 0.485 2003 2004 2005 IA 0.485 0.485 0.485 0.5 Slower in selling inventory total asset turnover = sale/average total asset 2003: TA turnover = 100/((300+360)/2) = 0.30 0.30 0.30 0.30 0.4

Management efficient ratios Average collection period (days receivable) = average AR/sales per day average time between date of sale and date payment received 2003: {(25+30)/2}/(100/365) = 100.4 2003 2004 2005 IA 100.4 100.4 100.4 60 fixed asset turnover = sale/average of fixed asset 2003: 100/{(150+180)/2}=0.600 0.606 0.606 0.606 0.7

Some comments on efficient management ratios Total asset turnover of G.I. < industry average (0.3<0.4) fixed asset turnover < Industry average (0.60 < 0.7): inefficient in using fixed asset days receivable > industry average (100.4 > 60): receive cash longer than average, poor receivable procedure Inventory turnover < industry average (0.485<0.5): turn inventory into sale slower than average, poor inventory management

Leverage ratios Interest coverage (times interest earned) = EBIT/Interest expense Leverage ratio: Assets/Equity = 1 + Debt/Equity Debt ratio = debt/equity

Profitability ratios ROA = EBIT/(average total assets) ROE = NI/(average total equity) Return on sale (profit margin) = EBIT/Sales

Market price ratios Market-to-book = price per share/ book value per share Lower market-to-book stocks: safer stocks Price-to-earning (P/E) = market price per share / EPS Low P/E, more bargain

Comparability Problems GAAP (Generally Accepted Accounting Principles) is not unique Inventory valuation: LIFO vs FIFO Depreciation: Straight line vs Accelerated Quality of earnings affected by: Allowance of bad debt; nonrecurring items; stock option; revenue recognition; off-balance-sheet assets and liabilities GAAP vs IAS (International Accounting Standards)

Quality of Earnings: Areas of Accounting Choices Allowance for bad debts: When companies sell goods using credit, need to have allowance for bad debts. This is the estimate. Different companies have different estimates Non-recurring items: Unusual income, does not happen regularly. Reserves management: Different companies have different estimates of reserve for future investment Stock options Companies use stock options as bonus therefore it should be reported as expenses and need to price the options Revenue recognition Off-balance sheet assets and liabilities

Figure 13.3 Adjusted Versus Reported Price-Earnings Ratios