Overview of Financial Analysis o SPECIFY THE OBJECTIVES OF THE ANALYSIS o Focus on who is the financial statement user o The identity of the user helps define what information is needed Financial The company’s return on equity has dipped considerably over the last period I had better sell that stock ASAP!

Steps of a F/S Analysis 1.Establish objectives of the analysis 2.Study the industry and relate industry climate to current and projected economic developments - o a growth industry? o a dying industry? o a changing industry? o Develop knowledge of firm and quality of management o Evaluate financial statements using basic tools o Summarize findings o Reach conclusions relevant to established objectives

Potential Financial Statement Users: o Creditors o Investors o Managers o Who else? o What types of questions do each of these users seek answers to?

Data sources o Financial statements (and notes) o Auditor’s report o MD&A o Supplementary schedules o 10K and 10Q reports filed with SEC o Computerized data bases o Info on industry norms/ratios o Info on particular companies/industries/mutual funds o Articles in popular/business press o Websites

Tools for analysis o Common size financial statements o Financial ratios o Trend analysis o Structural analysis o Industry comparisons o Common sense and judgment

Financial Ratio Categories o Liquidity Ratios measure a firm’s ability to meet cash needs as they arise o Activity Ratios measure the liquidity of specific assets and the efficiency of managing assets

Ratio Categories (continued) o Leverage Ratios measure the extent of a firm’s financing with debt relative to equity and its ability to cover interest and other fixed charges o Profitability Ratios measure the overall performance of a firm and its efficiency in managing assets, liabilities and equity

Caution! o Ratios are valuable, BUT….. o They do not provide answers in an of themselves and are not predictive o They should be used with other elements of financial analysis o There are no “rules of thumb” that apply to interpretation of ratios

Profitability Ratios o Gross Profit Margin Gross Profit/Net Sales o Operating Profit Margin Operating Profit/Net Sales o Net Profit Margin Net Earnings/Net Sales o All measure firm’s ability to translate sales dollars into profits

Profitability Ratios (continued) o Return on Investment (or Return on Assets) Net Earnings/Total Assets o Return on Equity Net Earnings/Stockholders’ Equity o Both measure overall efficiency of firm in managing investment in assets and generating return to stockholders

2005 KD Hatheway-Dial Average Operating Assets Net Operating Income = Return on InvestmentROI o Return on Investment (ROI) o Net operating income o Income before interest and taxes o Operating assets o Assets held for operating purposes ONLY o i.e. cash, accounts receivable, inventory, plant and equipment

Understanding ROI 2005 KD Hatheway-Dial ROI=MarginXTurnover = Operating Margin = Turnover Net Operating Income Sales Sales Average Operating Assets

Understanding ROI 2005 KD Hatheway-Dial 12.5%=X2.5 = 5% = 2.5 $10,000 $80,000 $200,000 $200,000 X 100 5%

APPLYING ROI 2005 KD Hatheway-Dial 23.25%= X2.75 = = 2.75 $18,600 $80,000 $220,000 $220,000 10% Increased Sales without Any Increase in Operating Assets (assume 6% increase in operating expenses) X % increase with 10% increase in sales

APPLYING ROI 2005 KD Hatheway-Dial 36.25%=14.5% X2.50 = 14.5% = 2.50 $29,000 $80,000 $200,000 $200,000 10% Decrease in operating expenses and no change in sales X % increase with 10% decrease in operating expenses

APPLYING ROI 2005 KD Hatheway-Dial 13.90%=5.0% X2.78 = 5.0% = 2.78 $10,000 $72,000 $200,000 $200,000 10% Decrease in operating assets and no change in sales or operating expenses X % increase with 10% decrease in operating assets

APPLYING ROI 2005 KD Hatheway-Dial 16.25%=6.8% X2.39 = 6.8% = 2.39 $14,300 $88,000 $210,000 $210,000 10% increase in operating assets and 5% change in sales and 3% operating expenses X % increase with 10% decrease in operating assets

Profitability Ratios (continued) o Cash Flow Margin Cash Flow from Operating Activities /Net Sales Measures ability to translate sales into cash (with which to pay bills)

Profitability Ratios (continued) o Cash Return on Assets Cash Flow from Operating Activities /Total Assets Useful comparison to return on investment Indicates firm’s ability to generate cash from utilizing its assets

Liquidity Ratios o Current Ratio Current Assets/Current Liabilities Measures ability to meet short-term cash needs o Quick or Acid Test Ratio Current Assets-Inventory/Current Liabilities Measure ability to meet short-term cash needs more rigorously o Cash Flow Liquidity Ratio Cash+Marketable Securities+Cash Flow from Operating Activities/Current Liabilities Focuses on ability of the firm to generate operating cash flows as a source of liquidity

Activity Ratios o Average Collection Period Accounts Receivable/Average Daily Sales Helps gauge liquidity of accounts receivable (ability to collect cash from customers) o Accounts Receivable Turnover Net Sales/Accounts Receivable Another measure of efficiency of firm’s collection and credit policies

Activity Ratios (continued) o Inventory Turnover Cost of Goods Sold/Inventory Measures efficiency of inventory management o Fixed Asset and Total Asset Turnover Net Sales/Net PP&E (Fixed Asset T/O) Net Sales/Total Assets (Total Asset T/O) Both assess effectiveness in generating sales from investment in assets

Leverage: Debt Ratios o Debt Ratio Total Liabilities/Total Assets o Long-Term Debt to Total Capitalization Long-term Debt/Long-term Debt + Stockholders’ Equity o Debt to Equity Ratio Total Liabilities/Stockholders’ Equity o All three measure extent of firm’s financing with debt

Leverage: Coverage Ratios o Proportion and amount of debt in capital structure is important to analyst o Tradeoff between risk and return o Use of debt involves risk -- commitment to fixed charges o Fixed charges must be COVERED -- following are some ratios to assess coverage

Coverage Ratios (continued) o Times Interest Earned Operating Profit/Interest Expense Indicates how well operating earnings cover fixed interest charges o Fixed Charge Coverage Operating Profit + Lease Payments/Interest Expense + Lease Payments Broader measure of how well operating earnings cover fixed charges

Coverage Ratios (continued) o Cash Flow Adequacy Cash Flow from Operating Activities/ Average Annual Long-Term Debt Maturities Measures firm’s ability to cover long- term debt maturities each year Rationale is that over the long-run operating cash flows must be adequate to cover investing activities financed with debt

Other Ratios o Earnings per Common Share Net Earnings/Average Common Shares Outstanding Indicates return on a per share basis o Price to Earnings Market Price of Common Stock/Earnings per Common Share Expresses a multiple the stock market places on earnings

Other Ratios (continued) o Dividend Payout Dividends per Share/Earnings per Share Shows percentage of earnings paid out to stockholders o Dividend Yield Dividends per Share/Market Price of Common Share Shows rate earned by shareholders from dividends relative to current stock price