(C) 2007 Prentice Hall, Inc.5-1 The Analysis of Financial Statements Ratios are tools and their value is limited when used alone. The more tools used, the better the analysis. For example, you can’t use the same golf club for every shot and expect to be a good golfer. The more you practice with each club, however, the better able you will be to gauge which club to use on one shot. So to, we need to be skilled with the financial tools we use. - Diane Morrison - CEO, R.E.C. Inc.

(C) 2007 Prentice Hall, Inc.5-2 Objectives of Analysis Remember--the identity of the user helps define what information is needed Objectives will vary depending on the  perspective of the  perspective of the financial statement user  specific questions that are addressed by the analysis

(C) 2007 Prentice Hall, Inc.5-3 Creditors A creditor is ultimately concerned with the ability of an existing or prospective borrower to make interest and principal payments on borrowed funds

(C) 2007 Prentice Hall, Inc.5-4 Investors An investor attempts to arrive at an estimation of a company’s future earnings stream in order to attach a value to the securities being considered for purchase or liquidation

(C) 2007 Prentice Hall, Inc.5-5 Tools and Techniques Common-size financial statements Financial ratios Trend analysis Industry comparisons These include: Most important: Common sense and judgment

(C) 2007 Prentice Hall, Inc.5-6 Common-Size Financial Statements Express each account on the  balance sheet as a percentage of total assets  income statement as a percentage of net sales

(C) 2007 Prentice Hall, Inc.5-7 Key Financial Ratios Standardize financial data in terms of mathematical relationships expressed in the form of PercentagesTimesDays

(C) 2007 Prentice Hall, Inc.5-8 Key Financial Ratios (cont.)  Liquidity (Short-term liquidity)  Activity  Leverage (Long-term solvency)  Profitability  Market

(C) 2007 Prentice Hall, Inc.5-9 Liquidity Ratios: Short-Term Solvency Measures ability to meet short-term cash needs Current Ratio Current assets Current liabilities

(C) 2007 Prentice Hall, Inc.5-10 Liquidity Ratios: Short-Term Solvency (cont.) Measures ability to meet short-term cash needs more rigorously by eliminating inventory Quick or Acid-Test Ratio Current assets - Inventory Current liabilities (Cash+short-term investments + A/R) current liabilities

(C) 2007 Prentice Hall, Inc.5-11 Liquidity Ratios: Short-Term Solvency (cont.) Focuses on ability of the firm to generate operating cash flows as a source of liquidity Cash Flow Liquidity Ratio *Cash flow from operating activities Cash + Marketable securities + CFO * Current liabilities

(C) 2007 Prentice Hall, Inc.5-12 Liquidity Ratios

(C) 2007 Prentice Hall, Inc.5-13 Activity Ratios: Asset Liquidity, Asset Management Efficiency Another measure of efficiency of firm’s collection and credit policies Accounts Receivable Turnover

(C) 2007 Prentice Hall, Inc.5-14 Activity Ratios: Asset Liquidity, Asset Management Efficiency (cont.) Another measure of firm’s efficiency in managing its inventory Inventory Turnover

(C) 2007 Prentice Hall, Inc.5-15 Activity Ratios: Asset Liquidity, Asset Management Efficiency (cont.) Another way to gain insight into a firm’s pattern of payment to suppliers Payables Turnover

(C) 2007 Prentice Hall, Inc.5-16 Cash Conversion Cycle or Net Trade Cycle  Buying or manufacturing inventory, with some purchases on credit  Selling inventory, with some sales on credit  Collecting the cash The normal cycle of a firm that consists of:

(C) 2007 Prentice Hall, Inc.5-17 Cash Conversion Cycle or Net Trade Cycle (cont.) Key balance sheet accounts that affect cash flow from operating activities  Accounts Receivable  Inventory  Accounts Payable Helps the analyst understand why cash flow generation has improved or deteriorated by analyzing:

(C) 2007 Prentice Hall, Inc.5-18 Cash Conversion Cycle or Net Trade Cycle (cont.) Average collection period Plus Days inventory held Minus Days payable outstanding Equals Cash conversion or net trade cycle Calculated as follows:

(C) 2007 Prentice Hall, Inc.5-19 Activity Ratios: Asset Liquidity, Asset Management Efficiency (cont.) Assesses effectiveness in generating sales from investments in fixed assets Fixed Asset Turnover Net sales Net property, plant, equipment (Average)

(C) 2007 Prentice Hall, Inc.5-20 Activity Ratios: Asset Liquidity, Asset Management Efficiency (cont.) Assesses effectiveness in generating sales from investments in all assets Total Asset Turnover Net sales Total assets (Average)

(C) 2007 Prentice Hall, Inc.5-21 Activity Ratios- Summary

(C) 2007 Prentice Hall, Inc.5-22 Activity Ratios- Summary

(C) 2007 Prentice Hall, Inc.5-23 Leverage Ratios: Debt Financing and Coverage Considers the proportion of all assets that are financed with debt Debt Ratio Total liabilities Total assets

(C) 2007 Prentice Hall, Inc.5-24 Leverage Ratios: Debt Financing and Coverage (cont.) Reveals the extent to which long-term debt is used for the firm’s permanent financing (both long- term debt and equity) Long-term Debt to Total Capitalization Long–term debt Long-term debt + Stockholders’ equity

(C) 2007 Prentice Hall, Inc.5-25 Leverage Ratios: Debt Financing and Coverage (cont.) Measures the riskiness of the firm’s capital structure in terms of the relationship between the funds supplied by creditors (debt) and investors (equity) Debt to Equity Total liabilities Stockholders’ equity

(C) 2007 Prentice Hall, Inc.5-26 Leverage Ratios: Debt Financing and Coverage (cont.) Indicates how well operating earnings cover fixed interest expenses Times Interest Earned Operating profit Interest expense

(C) 2007 Prentice Hall, Inc.5-27 Leverage Ratios: Debt Financing and Coverage (cont.) Measures how many times interest payments can be covered by cash flow from operations before interest and taxes Cash Interest Coverage CFO + interest paid + taxes paid Interest paid

(C) 2007 Prentice Hall, Inc.5-28 Leverage Ratios: Debt Financing and Coverage (cont.) Broader measure of how well operating earnings cover fixed charges Fixed Charge Coverage *Rent expense = operating lease payments Operating profit + Rent expense Interest expense + Rent expense

(C) 2007 Prentice Hall, Inc.5-29 Leverage Ratios: Debt Financing and Coverage (cont.) Measures firm’s ability to cover capital expenditures, long-term debt payments and dividends each year Cash Flow Adequacy Cash flow from operating activities Capital expenditures + debt repayments + dividends paid

(C) 2007 Prentice Hall, Inc.5-30 Leverage Ratios: Debt Financing and Coverage Summary

(C) 2007 Prentice Hall, Inc.5-31 Profitability Ratios: Overall Efficiency and Performance Measures ability to translate sales into profit after consideration of cost of products sold Gross Profit Margin Gross profit Net sales

(C) 2007 Prentice Hall, Inc.5-32 Profitability Ratios: Overall Efficiency and Performance (cont.) Measures ability to translate sales into profit after consideration of operating expenses Operating Profit Margin Operating profit Net sales

(C) 2007 Prentice Hall, Inc.5-33 Profitability Ratios: Overall Efficiency and Performance (cont.) Measures ability to translate sales into profit after consideration of all expenses and revenues, including interest, taxes and nonoperating items Net Profit Margin Net earnings Net sales

(C) 2007 Prentice Hall, Inc.5-34 Profitability Ratios: Overall Efficiency and Performance (cont.) Measures ability to translate sales into cash (with which to pay bills!) Cash Flow Margin Cash flow from operating activities Net sales

(C) 2007 Prentice Hall, Inc.5-35 Profitability Ratios: Overall Efficiency and Performance (cont.) Measures rate of return on stockholders’ investment Return on Equity (ROE) Net earnings Stockholders’ equity (Average)

(C) 2007 Prentice Hall, Inc.5-36 Profitability Ratios: Overall Efficiency and Performance (cont.) Measures overall efficiency of firm in managing investment in assets and generating profits Return on Total Assets (ROA) or Return on Investment (ROI) Net earnings Total assets (Average)

(C) 2007 Prentice Hall, Inc.5-37 Relating the Ratios —The Du Pont System Is helpful to complete the evaluation of a firm by considering the interrelationship among the individual ratios The Du Pont System helps the analyst see how the firm’s decisions and activities over the course of an accounting period interact to produce an overall return to the firm’s shareholders, the return on equity

(C) 2007 Prentice Hall, Inc.5-38 Relating the Ratios —The Du Pont System (cont.) The summary ratios used are the following: (1) Net profit margin (2) Total asset turnover (3) Return on investment (3) Return on investment (4) Financial leverage (5) Return on equity Net income Net sales Net income Net sales X Total assets = Total assets Net sales X Total assets = Total assets Net income Total assets Net income Total assets X Stockholder equity = Stockholder equity

(C) 2007 Prentice Hall, Inc.5-39 Profitability Ratios: Overall Efficiency and Performance (cont.)  Measures firm’s ability to generate cash from the utilization of its assets  Useful comparison to ROA Cash Return on Assets Cash flow from operating activities Total assets (Average)

(C) 2007 Prentice Hall, Inc.5-40 Profitability Ratios-Summary

(C) 2007 Prentice Hall, Inc.5-41 Profitability Ratios-Summary

(C) 2007 Prentice Hall, Inc.5-42 Market Ratios 1. Earnings per common share 2. Price-to-earnings 3. Dividend payout 4. Dividend yield Four market ratios of particular interest to the investor are

(C) 2007 Prentice Hall, Inc.5-43 Market Ratios (cont.) Market Ratios (cont.) Provides the investor with a common denominator to gauge investment returns Earnings per Common Share Net earnings Average shares outstanding

(C) 2007 Prentice Hall, Inc.5-44 Market Ratios (cont.) Market Ratios (cont.) Relates earnings per common share to the market price at which the stock trades, expressing the “multiple” that the stock market places on a firm’s earnings Price-to-Earnings Market price of common stock Earnings per share

(C) 2007 Prentice Hall, Inc.5-45 Market Ratios (cont.) Market Ratios (cont.) Determined by the formula cash dividends per share divided by earnings per share Dividend Payout Dividends per share Earnings per share

(C) 2007 Prentice Hall, Inc.5-46 Market Ratios (cont.) Market Ratios (cont.) Shows the relationship between cash dividends and market price Dividend Yield Dividends per share Market price of common stock

(C) 2007 Prentice Hall, Inc.5-47 Market Ratios

Financial Analysis  Credit Analysis  Equity Analysis

(C) 2007 Prentice Hall, Inc.5-49 Creditors  What is the borrowing cause?  What is the firm’s capital structure?  What will be the source of debt repayment?

(C) 2007 Prentice Hall, Inc.5-50 Credit Rating  Business Risk  Industry characteristics  Company position  Management  Financial Risk  Financial characteristics  Financial Policy  Profitability  Capital Structure  Cash Flow Protection  Financial flexibility

(C) 2007 Prentice Hall, Inc.5-51 Standard & Poor’s rating method 1. EBIT interest coverage 2. EBITDA interest coverage 3. Funds from operations/Total debt % 4. Free operating cash flow/Total debt % 5. Return on capital % 6. Operating income/Sales 7. Long-term debt/Capital 8. Total debt/Capital

(C) 2007 Prentice Hall, Inc.5-52 Standard and Poors Corporate Ratings

(C) 2007 Prentice Hall, Inc.5-53 Financial distress The deterioration in a company’s financial condition such that its ability to repay debt is impaired

(C) 2007 Prentice Hall, Inc.5-54 Prediction of financial distress Univariate models  Beaver (1966) relied on Cash flow to total debt Cash flow to total debt Net income to total assets Net income to total assets Total debt to total assets Total debt to total assets Working capital to total assets Working capital to total assets Current ratio Current ratio No-credit (defensive) interval No-credit (defensive) interval

(C) 2007 Prentice Hall, Inc.5-55 Prediction of financial distress Multivariate models  Altman Z-score  (Current assets – current liabilities)/total assets (weight-1,2)  Retained earnings/Total assets (weight-1,4)  EBIT/Total assets (weight-3,3)  Preferred and common stock market value/Book value of liabilities (weight-0,6)  Sales/Total assets (weight-1,0)

(C) 2007 Prentice Hall, Inc.5-56 Altman Z-score  Z> 2,99  Not in financial distress  Z< 1,81  In financial stress  2,99>Z>1,81  Uncertain

(C) 2007 Prentice Hall, Inc.5-57 Altman Z score Anadolu Cam

(C) 2007 Prentice Hall, Inc.5-58 Additional considerations  Mezzanine items  Could be debt or equity  Off-balance-sheet liabilities  Operating leases  Contingent liabilities  Environmental liabilities

(C) 2007 Prentice Hall, Inc.5-59 Equity Analysis  Buy-side  Work for an institutional investors (mutual fund)  Make internal recommendations regarding the purchase of equity securities  Might review reports of sell-side analysts  Sell-side  Work for brokerage firms  Issue reports for retail and institutional customers

(C) 2007 Prentice Hall, Inc.5-60 Valuation  Current value V 0 is a function of  Present value of next year’s cash flow, CF 1  Required rate of return, r  Expected constant growth rate, g

(C) 2007 Prentice Hall, Inc.5-61 Equity Analysis Provides information regarding 1. The future cash flow generating ability of the firm 2. The growth (or lack thereof) of those cash flows 3. The risk of those cash flows, and 4. The risk-free rate commanded by the market

(C) 2007 Prentice Hall, Inc.5-62 Top-Down Analysis  Begin at highest (economy) level  Allocation between domestic and international equities  Market sectors  Industries (within a sector)  End with evaluation of specific companies

(C) 2007 Prentice Hall, Inc.5-63 Bottom-Up Analysis  Begin with individual companies  Look for key strengths  Screen large data bases for attractive characteristics  Compustat, Bloomberg, Baseline  Search for a combination of characteristics

(C) 2007 Prentice Hall, Inc.5-64 Five Steps of a Financial Statement Analysis  Who are you and why are you interested in this company?  What questions would you like to have answered?  What info is vital to the decision at hand? Establish objectives of the analysis Step 1

(C) 2007 Prentice Hall, Inc.5-65 Five Steps of a Financial Statement Analysis (cont.) Study the industry in which the firm operates and relate industry climate to current and projected economic developments Step 2

(C) 2007 Prentice Hall, Inc.5-66 Five Steps of a Financial Statement Analysis (cont.)  How well does this firm appear to be run?  Are they taking advantage of opportunities?  Are they innovative, forward-looking, etc? Step 3 Develop knowledge of the firm and the quality of management

(C) 2007 Prentice Hall, Inc.5-67 Five Steps of a Financial Statement Analysis (cont.)  Common-size financial statements  Key financial ratios  Trend analysis  Comparison with industry competitors Step 4 Evaluate financial statements–tools include:

(C) 2007 Prentice Hall, Inc.5-68 Five Steps of a Financial Statement Analysis (cont.)  Short-term liquidity  Operating efficiency  Capital structure and long-term solvency  Profitability  Market ratios  Segmental analysis (when relevant) Step 4 Evaluate financial statements–areas include:

(C) 2007 Prentice Hall, Inc.5-69 Five Steps of a Financial Statement Analysis (cont.)  Reach conclusions about the firm relevant to your established objectives Step 5 Summarize findings based on analysis

(C) 2007 Prentice Hall, Inc.5-70 Financial Statements An Overview Map