Module 3 Analyzing and Interpreting Financial Statements

Common Questions that F/S Analysis Can Help To Answer Creditor Creditor Investor Investor Manager Manager Can the company pay the interest and principal on its debt? Does the company reply too much on nonowner financing? Does the company earn an acceptable return on invested capital? Is the gross profit margin growing or shrinking? Does the company effectively use nonowner financing? Are costs under control? Are the company’s markets growing or shrinking? Do observed changes reflect opportunities or threats? Is the allocation of investment across different assets too high or too low?

Ratio Analysis Examining various income statement and balance sheet components in relation to one another facilitates financial statement analysis. This type of examination is called ratio analysis. Examining various income statement and balance sheet components in relation to one another facilitates financial statement analysis. This type of examination is called ratio analysis. This module focuses on the disaggregation of Return Measures into This module focuses on the disaggregation of Return Measures into 1. Level I – RNOA and LEV 2. Level II – Profit Margins and Turnover 3. Level III – GPM, SGA, ART, INVT, PAT, APT, WCT 4. As well as Liquidity and Solvency Measures

Analysis Structure

Return on Equity Return on equity (ROE) is computed as: Return on equity (ROE) is computed as: ROE = Net Income / Average Equity ROE = Net Income / Average Equity

Key Definitions

Observed Medians of Variables

Level 1 Analysis – RNOA and Leverage

Return on Net Operating Assets (RNOA) RNOA = NOPAT / Average NOA where, NOPAT is net operating profit after tax NOA is net operating assets

Operating and Nonoperating Assets/Liabilities

Simplified Operating and Nonoperating Balance Sheet

NOPAT Net operating profit includes Net operating profit includes Operating revenues less Operating revenues less Operating expenses (COGS, SG&A, Taxes) Operating expenses (COGS, SG&A, Taxes) Excluded are after-tax earnings from investments returns and interest expenses. Excluded are after-tax earnings from investments returns and interest expenses.

Operating/Nonoperating vs. Core/Transitory

Financial Leverage and Risk LEV is the other component of ROE LEV is the other component of ROE Given that increases in financial leverage increase ROE, why are all companies not 100% debt financed? Given that increases in financial leverage increase ROE, why are all companies not 100% debt financed? The answer is because debt is risky. This increased risk increases the expected return that investors require to provide capital to the firm. The answer is because debt is risky. This increased risk increases the expected return that investors require to provide capital to the firm. Higher financial leverage also results in a higher interest rate on the company’s debt. Higher financial leverage also results in a higher interest rate on the company’s debt. Standard & Poor’s and Moody’s Investor Services ratings partly determine the debt’s interest rate—with lower quality ratings yielding higher interest rates and vice-versa. Standard & Poor’s and Moody’s Investor Services ratings partly determine the debt’s interest rate—with lower quality ratings yielding higher interest rates and vice-versa. So, all else equal, higher financial leverage lowers a company’s debt rating and increases the interest rate it must pay. So, all else equal, higher financial leverage lowers a company’s debt rating and increases the interest rate it must pay.

Leverage and Income Variability

Level II Analysis – Margin and Turnover

Margin vs. Turnover

NOPAT Margin

Turnover of NOA

Level 3 Analysis — Disaggregation of Margin and Turnover

Gross Profit Margin It allows a focus on average unit mark-ups It allows a focus on average unit mark-ups A high gross profit margin is preferred to a lower one, which also implies that a company has relatively more flexibility in product pricing. A high gross profit margin is preferred to a lower one, which also implies that a company has relatively more flexibility in product pricing.

Gross Profit Margin Two main factors determine gross profit margins: Two main factors determine gross profit margins: 1. Competition – as the level of competition intensifies, more substitutes become available, which limits a company’s ability to raise prices and pass along price increases to customers. 2. Product mix – if the proportion of lower price, higher volume products increases relative to that of higher priced, lower volume products, then gross profit dollars may stay the same, but gross profit margin declines.

Operating Expense Margin Operating expense ratios (percents) are used to examine the proportion of sales consumed by each major expense category. Operating expense ratios (percents) are used to examine the proportion of sales consumed by each major expense category. Expense ratios are calculated as follows: Expense ratios are calculated as follows: Operating expense percentage = Expense item/Net sales

Turnover Turnover measures relate to the productivity of company assets. Such measures seek to answer the amount of capital required to generate a specific sales volume. Turnover measures relate to the productivity of company assets. Such measures seek to answer the amount of capital required to generate a specific sales volume. Turnover ratios are calculated as follows: Turnover ratios are calculated as follows: Turnover = Sales volume/Average Assets As turnover increases, there is greater cash inflow as cash outflow for assets to support the current sales volume is reduced. As turnover increases, there is greater cash inflow as cash outflow for assets to support the current sales volume is reduced.

Accounts Receivable Turnover (ART)

Inventory Turnover (INVT)

L-T Operating Asset Turnover (LTOAT)

Accounts Payable Turnover (APT)

Net Operating Working Capital Turnover (WOCT)

Liquidity and Solvency Measures Liquidity refers to cash: how much we have, how much is expected, and how much can be raised on short notice. Liquidity refers to cash: how much we have, how much is expected, and how much can be raised on short notice. Solvency refers to the ability to meet obligations; primarily obligations to creditors, including lessors. Solvency refers to the ability to meet obligations; primarily obligations to creditors, including lessors.

Cash Operating Cycle Average Cash (Operating) Cycle - the period of time from cash to inventories to receivables to cash. Average Cash (Operating) Cycle - the period of time from cash to inventories to receivables to cash.

Current and Quick Ratio

Solvency Ratios

Flow Ratios

Bankruptcy Prediction

Limitations of Ratio analysis

Vertical and Horizontal Analysis

Derivation of ROE Disaggregation