CHAPTER THREE Financial Statement Analysis J. D. Han

Learning Objectives 1. How do we measure the health and the prospect of a company? Unfortunately, one indicator does not give a whole picture. Unfortunately, one indicator does not give a whole picture. 2. What types of ratios are used in financial analysis? 3. What are the trade-offs among these ratios? Illustrate them with the DuPont system of financial analysis of return on equity. Illustrate them with the DuPont system of financial analysis of return on equity.

3. 1 Learning Objectives 4.What kinds of distortions would inflation (changing prices) cause in the financial statement and on the income statement respectively? 5.Discuss some of the implications of foreign exchange rates for Canadian companies with global operations.

3.2 Ratio Analysis  Ratios are helpful for comparison purposes  Ratios are divided into four categories: 1. Liquidity Ratios 2. Leverage and Coverage Ratios 3. Profitability and Activity Ratios 4. Market Value Ratios

Liquidity Ratios: measuring a company’s short-term ability to pay its debt Liquidity Ratios: measuring a company’s short-term ability to pay its debt Current Ratio = current assets Current Ratio = current assets current liabilities current liabilities Most widely used liquidity ratio Most widely used liquidity ratio A value of > 2 is considered a crude suitable measurement for current ratio A value of > 2 is considered a crude suitable measurement for current ratio What is ‘working capital’? What is ‘working capital’?

Liquidity Ratios Used to evaluate a business ’ ability to meet current obligations when inventory is considered to be a concern Used to evaluate a business ’ ability to meet current obligations when inventory is considered to be a concern Acid Test Acid Test Quick ratio = current assets – inventories current liabilities current liabilities

Liquidity Ratios Indicates an organization ’ s efficiency of inventory management Indicates an organization ’ s efficiency of inventory management  inventory turnover signals efficient management  inventory turnover signals efficient management Inventory turnover = cost of goods sold average inventory average inventory

Liquidity Ratios Indicates the average number of days that credit sales are outstanding Indicates the average number of days that credit sales are outstanding Avg. collection period = receivables avg. daily credit sales avg. daily credit sales

Leverage and Coverage Ratios Common measure of a firm ’ s financial leverage Common measure of a firm ’ s financial leverage Used as a safety margin that shareholders are provided in the event of liquidation Used as a safety margin that shareholders are provided in the event of liquidation Debt-to-equity = long-term debt shareholders’ equity

Leverage and Coverage Ratios Broad measurement that looks at the proportion of a firm ’ s total assets that are financed through debt and other liabilities Broad measurement that looks at the proportion of a firm ’ s total assets that are financed through debt and other liabilities Total debt-to-asset = total debt total assets

Leverage and Coverage Ratios Measures the amount of assets a firm finances with debt or equity Measures the amount of assets a firm finances with debt or equity The  ratio, the proportion of company ’ s assets financed through equity  The  ratio, the proportion of company ’ s assets financed through equity  Equity multiplier = Total assets total equity

Leverage and Coverage Ratios Used to detect excessive leverage Used to detect excessive leverage An indicator of the safety of a firm ’ s periodic interest payments An indicator of the safety of a firm ’ s periodic interest payments Times interest earned = EBIT interest charges interest charges

Profitability and Activity Ratios: Different Measures of Profits Sales (revenues) – Cost of Goods sold – Operating Expenses = EBIT = NOP – Financing Charges =EBT – Financing Charges =EBT – Income Taxes =Net Profits – Dividends on Preferred Shares= Profit available to common shareholders

Profitability and Activity Ratios: asses the overall managerial efficiency and profitability Net operating margin = EBIT sales sales Gross operating margin = sales – COGS sales Asset turnover = sales total assets total assets

Profitability Ratios Broad measure of how well management is employing assets to earn profits Broad measure of how well management is employing assets to earn profits ROA = net profit total assets total assets

Profitability Ratios Measures how well management serves shareholders ’ interest by determining the profit generation per dollar of equity invested in the firm Measures how well management serves shareholders ’ interest by determining the profit generation per dollar of equity invested in the firm ROE = net profit shareholders’ equity shareholders’ equity

DuPont System Allows for analysis of critical components that influence ROE and help predict future trends Allows for analysis of critical components that influence ROE and help predict future trends The three ratios used in the DuPont system of financial analysis of return on equity are Profitability, Leverage, and Asset Turnover. The three ratios used in the DuPont system of financial analysis of return on equity are Profitability, Leverage, and Asset Turnover. For instance, this shows that you can raise ROE by decreasing the equity – what would be the resultant problem or trade-offs between short-term and long-term welfares of the firm? For instance, this shows that you can raise ROE by decreasing the equity – what would be the resultant problem or trade-offs between short-term and long-term welfares of the firm? ROE = net profit x sales x total assets sales total assets shareholders’ equity sales total assets shareholders’ equity

Market Value Ratios Most widely used market value ratio Most widely used market value ratio Reflects what investors are willing to pay for each dollar of reported annual common share earnings Reflects what investors are willing to pay for each dollar of reported annual common share earnings Price-Earnings Ratio = price per common share earning per common share earning per common share

Market Value Ratios Tobin’s q Ratio = Market Value of debt and equity replacement cost replacement cost Market-to-book ratio = Market Value of debt and equity Market-to-book ratio = Market Value of debt and equity book value of assets The difference between the replacement cost and the book value is “depreciation”, both technical and physical.

3.3 Common-Size Analysis  Involves converting dollar amounts on the financial statements into percentages  Helps compare financial statements and identify trends that are not caused by the overall size of the business  Enables comparison of companies of different size

Market Value Ratios Indicates the percentage of earning paid to shareholders in the form of dividends Indicates the percentage of earning paid to shareholders in the form of dividends Dividend payout = common share dividend common share earnings common share earnings Dividend yield = dividend per common share price per common share price per common share Widely used market value ratio Measures how much investors are willing to pay for a firm’s dividend Measures how much investors are willing to pay for a firm’s dividend

Summary 1.The four categories of ratios used in financial analysis are: Liquidity ratios highlight the firm ’ s short-term ability to meet financial obligations. Liquidity ratios highlight the firm ’ s short-term ability to meet financial obligations. Leverage ratios reflect the company ’ s long- term financing decisions, while coverage ratios indicate its long-term ability to service outstanding debt. Leverage ratios reflect the company ’ s long- term financing decisions, while coverage ratios indicate its long-term ability to service outstanding debt. Profitability and activity ratios portray the earnings power of an enterprise and the efficiency with which its resources are used. Profitability and activity ratios portray the earnings power of an enterprise and the efficiency with which its resources are used.

3.4 Effect of Inflation on Financial Statement Analysis 1) Effect on Balance Sheet (1) Inflation makes Book and Market Values of Asset diverge:  Asset Value in the Book = Historical Cost  Inflation increases the Market Value of Asset – the book value is below thi, being understated.  For instance, the apparent ROA is exaggerated. (2) Real Value of Debt falls with inflation:  Inflation decreases the Real Value of debt  A falling inflation rate, and deflation increases the Real Value of debt

3.4 Effect of Inflation on Financial Statement Analysis 2) Effects on Income Statement  Inflation exaggerates the inventory values, and thus earnings.  Inflation understates the cost of depreciation.  Overall, inflation overstates earnings.

3.6 International Considerations When firms hold assets and liabilities denominated in foreign currencies, the procedure for recognizing the gains or losses resulting from changes in foreign exchange rates becomes important. When firms hold assets and liabilities denominated in foreign currencies, the procedure for recognizing the gains or losses resulting from changes in foreign exchange rates becomes important.