1. Analysis of Financial Statements
Chapter 10

2. Analyzing the financial Statements
Why do investors have to analyze the financial statements ?
The ultimate goal of investors is to build a portfolio of investments that will provides rates of return that are consistent with the risk of the portfolio.
To reach this goal: we need to find the rate of return on each investment(asset) by finding the value of the asset.
To find the value of any earning asset: is to find the present value of the expected cash flow generated by the asset.
To find the present value of any asset: we must find an estimate of the discount rate (the required rate of return) and the expected cash flows
Finally, the main source to find these two estimates is: the financial statements.
Therefore, the crux of investment is valuation

3. Analyzing the financial Statements
To derive an estimate of the required rate of return we need to understand the business and the financial risks of the firm.
To estimate to estimate the future cash flows, we must understand the composition of cash flow and what will contribute to the short and long run growth of these cash flows. (*)
Financial statements are also the main source of information when deciding weather to lend money to a firm (by investing in bonds), or to buy options on a firm’s stock.(**)
*These two estimates are the focus of this chapter or in other words, you should understand how to estimate the variables in alternative valuation models
** in this chapter we will first introduce a corporation’s major financial statements and discuss why and how financial ratios are useful.
Also we will introduce four major areas of investments where financial ratios have been effectively employed.

4. 10.1 Major Financial Statements
Financial statements are intended to provide information on:
The resources available to management (assets)
How these resources are financed (liabilities & owner’s equity)
And what the firm accomplished with them (income)
Shareholder annual and quarterly reports include three required financial statements:
The balance sheet
Income statement
Statement of cash flows

5. 10.1.1 Generally Accepted Accounting Principles
Among the inputs used to construct a financial statements are generally accepted accounting principles (GAAP), which are formulated by Financial Accounting Standards Board. (FASB).
What purpose does GAAP serves?
The FASB recognizes that it will be improper for all companies to use identical and restrictive accounting principles . Some flexibility and choices are needed because industries differ and also firms within an industry are different than each other. This flexibility allows the firm’s managers to choose accounting standards that best reflect company practice.
* FASB requires that financial statements include footnotes that indicate which accounting principles were used by the company.

6. Balance Sheet
The balance sheet shows what recourses (assets) the firm controls and how it financed these assets.
It indicates the current and fixed assets available to the firm at a point in time. (the end of a year or a quarter)
How the firm has financed these assets is indicated by its mixture of current liabilities (account payable or short payable), long term liabilities (fixed debts and leases), and owners equity (proffered stock, common stock, and retained earnings)

7. Income statement
The income statement contains information on the operating performance of the firm during some period of time (a quarter or a year)
It contrast to the balance sheer, which is at a fixed point in time, the income statement indicates the flow of sales, expenses, and earnings during a period of time.

8. Statement of Cash Flow
We have mentioned in our discussion about valuation that cash flows are a critical input that firms are required to provide.
The Statement of cash flows integrates the effects on the firm’s cash flow of income(based on the most recent year’s income statement), and changes on balance sheet (based on 2 most recent annual balance sheet).
Analysts use these cash flow values to evaluate the risk and return of firm’s bonds and stocks.

9. 10.1.4 Statement of Cash Flow It has three sections:
Cash flow from operating activity
Cash flow from investing activity
Cash flow from financing activity
The total cash flow from all these three sections is the net change in the cash position of the firm and it equals the difference in the cash balance between the ending and beginning balance sheet.

10. Statement of Cash Flow
Cash Flow from Operating Activity: This section of the statement lists the sources and uses of cash that arise from the normal operations of a firm.
the net cash flow from operation is computed as:
= Net income + Depreciation (non cash revenue or expenses) +changes in net working capital items
Cash Flow from Investing Activities:
A firm makes investments in both its own fixed assets and the equity of other firms (ex. Joint ventures of the parent firm).
They are listed in the investment account in the balance sheet.
Any increase or decrease in these accounts is considered investment activities.
The cash flow from investing activities is the change in the gross plant and equipment + the change in the investment account.
The changes are positive if they represent a source of funds (eg. Sales of plant), otherwise, they are negative.
Most firms experience a negative cash flow from investment, why?

11. 10.1.4 Statement of Cash Flow Cash flow from Financing activities:
cash inflows (sources) are created by increasing notes payable and long term liability and equity accounts such as bond and stock issue. Cash outflow (uses), include decrease in these accounts.
Dividend payments are a significant financing cash outflow

12. Measure of Cash flow
Traditional cash flow: net income + non-cash expenses
Free cash flow: recognizes that some investing and financing activities are critical to the firm
Cash flow from operations – capital expenditures + disposition of property and equipment = free cash flow
EBITDA: Extremely liberal measure of cash flow

13. 10.1.6 Purpose of Financial Statement Analysis
Evaluate management performance in three areas:
Profitability
Efficiency
Risk
The ultimate goal of this analysis is to provide insights that will help us to project future management performance ( including pro forma balance sheet, income statement, cash flow and risk).
It’s the firm expected future performance that determines whether we should lend money to a firm or invest in it.

14. Analysis of Financial Ratios
Ratios are more informative that raw numbers
Ratios provide meaningful relationships between individual values in the financial statements

15. Importance of Relative Financial Ratios
Compare to other entities
Examine a firm’s performance relative to:
The aggregate economy
Its industry or industries(Most popular comparison)
Its major competitors within the industry
Its past performance (time-series analysis)

16. Five Categories of Financial Ratios
1.Common size statements
2.Internal liquidity (solvency)
3. Operating performance
a. Operating efficiency
b. Operating profitability
4. Risk analysis
a. Business risk
b. Financial risk
External liquidity risk
5. Growth analysis

17. Common Size Statements
Normalize balance sheets and income statement items to allow easier comparison of different size firms
A common size balance sheet expresses accounts as a percentage of total assets
A common size income statement expresses all items as a percentage of sales

18. Evaluating Internal Liquidity
Internal liquidity (solvency) ratios indicate the ability to meet future short-term financial obligations
Current Ratio examines current assets and current liabilities

19. Evaluating Internal Liquidity
Quick Ratio adjusts current assets by removing less liquid assets

20. Evaluating Internal Liquidity
Cash Ratio is the most conservative liquidity ratio

21. Evaluating Internal Liquidity
Receivables turnover
examines the liquidity of accounts receivable by calculating how often the firm’s receivables turn over.
The faster these accounts are paid, the sooner the firm gets the fund to pay off its own current liabilities
Receivables turnover can be converted into an average collection period

22. Evaluating Internal Liquidity
Inventory turnover how many times its sold during the year and the implied processing time
Inventory turnover relates inventory to sales or cost of goods sold (CGS)
Given the turnover values, you can compute the average inventory processing time
Average Inventory Processing Period = 365/Annual Turnover

23. Evaluating Internal Liquidity
Payable turnover
used to quantify the rate at which a company pays off its suppliers
Payable payment period = 365 days/payable turnover

24. Evaluating Internal Liquidity
Cash conversion cycle combines information from the receivables turnover, inventory turnover, and accounts payable turnover
Receivable Days
+Inventory Processing Days
-Payables Payment Period
= Cash Conversion Cycle

25. Evaluating Operating Performance
Ratios that measure how well management is operating a business
(1) Operating efficiency ratios
Examine how the management uses its assets and capital, measured in terms of sales dollars generated by asset or capital categories
(2) Operating profitability ratios
Analyze profits as a percentage of sales and as a percentage of the assets and capital employed

26. Operating Efficiency Ratios
Total asset turnover ratio
indicates the effectiveness of a firm’s use of its total asset base (net assets equals gross assets minus depreciation on fixed assets)
Its poor management to have an exceedingly high asset turnover relative to the industry, why?
It is equally poor management to have an extremely low asset turnover, why?

27. Operating Efficiency Ratios
Net fixed asset turnover reflects utilization of fixed assets.

28. Operating Profitability Ratios
Operating profitability ratios measure
1. The rate of profit on sales (profit margin)
2. The percentage return on capital employed
Gross Profit margin
measures the rate of profit on sales (gross profit equals net sales minus the cost of goods sold)

29. Operating Profitability Ratios
Operating profit margin measures the rate of profit on sales after operating expenses (operating profit is gross profit minus sales, general and administrative (SG + A) expenses. (or we call it EBIT)

30. Operating Profitability Ratios
Net profit margin relates net income to sales

31. Operating Profitability Ratios
Return on total capital relates the firm’s earnings to all capital in the enterprise

32. Operating Profitability Ratios
The DuPont System divides the ratio into several components that provide insights into the causes of a firm’s ROE and any changes in it

33. Operating Profitability Ratios
Profit Total Asset Financial
Margin Turnover Leverage = x

34. 10.6 Risk Analysis
Risk analysis examines the uncertainty of income flows for the total firm and for the individual sources of capital
Debt
Preferred stock
Common stock
The typical approach examines the major factors that cause a firm’s income flows to vary.
More volatile income mean greater risk (uncertainty) facing the investor.

35. Risk Analysis Business risk Financial risk
Total risk of a firm has two components:
Business risk
The uncertainty of income caused by the firm’s industry
Generally measured by the variability of the firm’s operating income over time
Financial risk
Additional uncertainty of returns to equity holders due to a firm’s use of fixed obligation debt securities
The acceptable level of financial risk for a firm depends on its business risk

36. Risk Analysis Business risk
Variability of the firm’s operating income over time
Standard deviation of the historical operating earnings series
A firm’s operating earning vary over time and its business risk is measured by the volatility of the firm’s operating income over time which is due to two factors:
Sales Variability
Operating Leverage

37. Risk Analysis Sales variability
is the prime determinant of operating earnings variability.
The variability of sales is mainly caused by a firm’s industry and is largely outside the control of management.
Some industries are cyclical (automobile vs retail food)

38. Risk Analysis Operating Leverage
The variability of a firm’s operating earning also depends on its mixture of production costs .
Total production cost of a firm with no fixed production costs would vary with sales, and operating profit would be a constant proportion of sales.
However, realistically, firms always have some fixed production cost (e.g. building. machinery) and this cost cause operating profit to vary more than sales.
Example: during slow sales periods, operating profit will decline by a larger percentage than sales, while during an economic expansion, operating profits will increase by a larger percentage than sales.
Fixed production costs cause profit volatility with changes in sales
Fixed production costs are operating leverage.

39. Risk Analysis Financial Risk
is the additional uncertainty of returns to equity holders due to a firm’s use of fixed financial obligation securities.
Bonds(debt) interest payments come before earnings are available to stockholders
These are fixed obligations

40. Risk Analysis Financial Risk
Similar to fixed production costs, the net earning available to stockholders after fixed interest payment will experience a larger percentage increase than operating earnings. And the opposite when business decline as a result of the fixed financial cost.
This debt financing increases the financial risk and possibility of default or bankruptcy.

41. Relationship between business risk and financial risk
Acceptable level of financial risk for a firm depends on its business risk (stable operating earning)
Example: retail food companies have stable operating earning over time, which implies low business risk and means that investors and bond rating firms will allow the firms to have higher financial risk.

42. Relationship between business risk and financial risk
Two sets of financial ratios help measure financial risk
Balance sheet ratios
Earnings or cash flow available to pay fixed financial charges

43. Financial Risk Proportion of debt (Balance sheet ratios)
A higher proportion of debt capital compared to equity capital makes earning more volatile, and increase the probability that a firm could default on the debt.
Higher proportion of debt ratio lead to financial risk

44. Financial Risk
Long-term debt/total capital ratio indicates the proportion of long-term capital derived from long-term debt capital

45. Financial Risk
Total debt ratios compare total debt (current liabilities plus long-term liabilities) to total capital (total debt plus total equity)

46. Financial Risk Earnings or Cash Flow Ratios
Relate the flow of earnings or cash flow available to meet the required interest payment.
Higher ratio means lower risk

47. Financial Risk Interest Coverage Ratio
This ratio indicates how many time the fixed interest charges are earned, based on the earnings available to pay these expenses.
Also, one minus the reciprocal of the interest coverage ratio indicates how far earnings could decline before it would be impossible to pay the interest charges from current earnings.

48. Financial Risk
Firms may also have non-interest fixed payments due for lease obligations
The risk effect is similar to bond risk

49. Total fixed charge coverage includes any noncancellable lease payments and any preferred dividends paid out of earnings after taxes

50. Financial Risk Cash flow coverage
The motivation for this ratio is that a firm’s earnings and cash flow will differ.
The cash flow value used is the cash flow from operating activity (it inclused depreciation, and the impact of all working capital changes)

51. Financial Risk Cash flow – long term debt ratio
The higher the percentage of cash flow to long term debt the stronger the company.(lower financial risk)

52. Financial Risk
Cash flow – total debt ratio

53. External Market Liquidity
Market Liquidity is the ability to buy or sell an asset quickly with little price change from a prior transaction assuming no new information
External market liquidity is a source of risk to investors

54. Analysis of Growth Potential
The analysis of sustainable growth potential examines ratios that indicate how fast a firm should grow.
This analysis is important for both lenders and owners.
Owners know that the value of the firm depends on its future growth in earnings ,cash flow, and dividends.
Creditors are interested because the future success is the major determinant of its ability to pay obligation.

55. Determination of Growth
The growth of any business depends on:
The amount of resources retained and reinvested in the entity
The rate of return earned on the reinvested funds
Therefore, the growth rate of equity earnings and cash flow is a function of two variables:

56. Determination of Growth
Therefore, the growth rate of equity earnings and cash flow is a function of two variables:
The percentage of net earnings retained (the firm’s retention rate)
The rate of return earned on the firm’s equity capital (ROE) because when earnings are retained, they become part of the firm’s equity.

57. Determination of Growth
= RR x ROE
where:
g = potential growth rate
RR = the retention rate of earnings
ROE = the firm’s return on equity
RR = 1 – (Dividend declared/net earning)

58. Determinants of Growth
ROE is a function of
Net profit margin
Total asset turnover
Financial leverage (total assets/equity)

59. Comparative Analysis of Ratios
Internal liquidity
Current ratio, quick ratio, and cash ratio
Operating performance
Efficiency ratios and profitability ratios
Financial risk
Growth analysis

60. The Quality of Financial Statements
Reflect reality rather than use accounting tricks or one-time adjustments to make things look better than they are

61. The quality of Balance sheet
High-quality balance sheets typically have
Conservative use of debt
Assets with market value greater than book
No liabilities off the balance sheet

62. The Quality of Financial Statements
High-quality income statements reflect repeatable earnings
Gains from nonrecurring items should be ignored when examining earnings
High-quality earnings result from the use of conservative accounting principles that do not overstate revenues or understate costs

63. The Value of Financial Statement Analysis
Financial statements, by their nature, are backward-looking
An efficient market will have already incorporated these past results into security prices, so why analyze the statements?
Analysis provides knowledge of a firm’s operating and financial structure
This aids in estimating future returns

64. Specific Uses of Financial Ratios
Stock valuation
2. Assigning credit quality ratings on bonds
3. Predicting insolvency (bankruptcy) of firms

65. Stock Valuation Models
Valuation models attempt to derive a value based upon one of several cash flow or relative valuation models
All valuation models are influenced by:
Expected growth rate of earnings, cash flows, or dividends
Required rate of return on the stock
Financial ratios can help in estimating these critical inputs

66. Stock Valuation Models
Financial Ratios
1. Average debt/equity
2. Average interest coverage
3. Average dividend payout
4. Average return on equity
5. Average retention rate
6. Average market price to book value
7. Average market price to cash flow
8. Average market price to sales
Nonratio Variables
1. Average growth rate of earnings

67. Financial Ratios and Bond Ratings
1. Long-term debt/total assets
2. Total debt/total capital
3. Net income plus depreciation (cash flow)/long term senior debt
4. Cash flow/total debt
5. Net income plus interest/interest expense (fixed charge coverage)
6. Cash flow/interest expense

68. Financial Ratios and Bond Ratings
7. Market value of stock/par value of bonds
8. Net operating profit/sales
9. Net income/owners’ equity (ROE)
10. Net income/total assets
11. Working capital/sales
12. Sales/net worth (equity turnover)
Nonratio variables
1. Subordination of the issue
2. Size of the firm (total assets)
3. Issue size
4. Par value of all publicly traded bonds of the firm

69. Financial Ratios and Insolvency (Bankruptcy)
1. Cash flow/total debt
2. Cash flow/long-term debt
3. Sales/total assets
4. Net income/total assets
5. EBIT/total assets
6. Total debt/total assets

70. 7. Market value of stock/book value of debt 8
7. Market value of stock/book value of debt 8. Working capital/total assets 9. Retained earnings/total assets 10. Current ratio 11. Cash/current liabilities 12. Working capital/sales

71. Limitations of Financial Ratios
Accounting treatments may vary among firms, especially among foreign firms
Firms may have divisions operating in different industries making it difficult to derive industry ratios
Results may not be consistent
Ratios outside an industry range may be cause for concern