1. Interpretation and Analysis of Financial Statement

2. Financial Statement Analysis
October 2000
Financial Analysis
Assessment of the firm’s past, present and future financial conditions
Done to find firm’s financial strengths and weaknesses
Primary Tools:
Financial Statements
Comparison of financial ratios to past performance , industry, sector and all firms
Ratios are compared to industry averages.
There are 14 to 16 common ratios grouped into 4 types.
Dun and Bradstreet and Robert Morris Associates give industry average ratios for hundreds of industries.
We will describe the types of ratios and focus on several important financial ratios.
Financial Statements 
1. Financial statements report a firm’s position at a point in time and on operations over some past period
2. Investors use financial statements to predict future earnings/dividends
3. Management uses financial statements to help anticipate future conditions and as starting point for planning actions that will affect future event
Financial ratios
1. Help evaluate a financial statement
2. Facilitate comparison of firms
C.J. Brown, M.M. Dutton and T.A. Rietz

3. Financial Statement Analysis
October 2000
Financial Statements
Balance Sheet
Income Statement
Cashflow Statement
 Balance Sheet
Statement of financial position at specific point in time 
Income Statement
Summarizes revenues and expenses over an accounting period
Statement of Cash Flows
Amount of cash generated during period is not what is shown on balance sheet
Tells you what happened to cash generated during specified period
Categories in Statement of Cash Flows
(a) Operating activities
(b) Investing activities
(c) Financing activities
Statement of Retained Earnings
Reports how much of earnings retained in business rather than paid out in dividends over the life of the firm
  Retained earnings is claim against assets
(a) Earnings retained to expand business
(b) Do not represent cash
C.J. Brown, M.M. Dutton and T.A. Rietz

4. Review: Major Balance Sheet Items
Financial Statement Analysis
October 2000
Review: Major Balance Sheet Items
Assets
Current assets:
Cash & securities
Receivables
Inventories
Fixed assets:
Tangible assets
Intangible assets
Liabilities and Equity
Current liabilities:
Payables
Short-term debt
Long-term liabilities
Shareholders' equity
Balance Sheet
Statement of financial position at specific point in time 
Shows assets owned by the firm and sources of the money used to purchase those assets.
Liquidity Order
Assets: length of time typically to convert to cash
Liabilities: how soon must be paid
Characteristics
Cash versus other assets
Only cash represents actual money
Noncash assets should produce cash in time
  Liabilities versus stockholders’ equity
Both claims against assets
  Breakdown of common equity accounts
Common stock
Retained earnings
Impacted by
Inventory accounting
Depreciation methods
Position at one point in time
C.J. Brown, M.M. Dutton and T.A. Rietz

5. Financial Perspective of the Firm
Operating
Assets
Debt I n t e r s
Equity
Revenues
Retained Profit
Net
Operating
Profit
Net
Income
Operating
Expenses
Dividends

6. Review: Major Income Statement Items
Financial Statement Analysis
October 2000
Review: Major Income Statement Items
Gross Profit = Sales - Costs of Goods Sold
EBITDA = Gross Profit - Cash Operating Expenses
EBIT = EBDIT - Depreciation - Amortization
EBT = EBIT - Interest
NI or EAT = EBT- Taxes
Net Income is a primary determinant of the firm’s cashflows and, thus, the value of the firm’s shares
Income Statement
1. Summarizes revenues and expenses over an accounting period
2. Information includes
(a) Net income available to common stockholders
  (b) Earnings per Share – “bottom line”
  (c) Usually compared to budget
3. The income statement serves as the basis for determining cashflows.
C.J. Brown, M.M. Dutton and T.A. Rietz

7. An Example: Abbreviated Income Statement
Financial Statement Analysis
October 2000
An Example: Abbreviated Income Statement
Sales Rs.25,265.00
Costs of Goods Sold -Rs.19,891.00
Gross Profit Rs.5,374.00
Cash operating expense -Rs.2,761.00
EBITDA 2,613.00
Depreciation & Amortization -Rs
Other Income (Net) -Rs.6.00
EBIT Rs.2,451.00
Interest -Rs.0.00
EBT Rs.2,451.00
Income Taxes -Rs
Special Income/Charges -Rs
Net Income (EAT) Rs.1,666.00
Dell had more than Rs.25 billion sales during the period.
A large part of revenues went to pay for the raw materials that went into production.
Depreciation reflects expenditure on a long-term asset which firm must expense over several years for tax purposes. It does not reflect an actual expenditure during this particular accounting period.
C.J. Brown, M.M. Dutton and T.A. Rietz

8. Financial Statement Analysis
October 2000
Financial Statement Analysis
Horizontal Analysis
Vertical Analysis
Common Size Statement
Ratio Analysis
Proforma Financial Statement
Measure Economic Value Added & Market Value Added
C.J. Brown, M.M. Dutton and T.A. Rietz

9. 1. Horizontal Analysis Increase/(Decrease) 2005 2004 Amount Percent
Sales Rs.41,500 Rs.37,850 Rs.3, %
Expenses 40, , , %
Net income 1, %

10. Trend % = Any year Rs. ÷ Base year Rs.
Trend Percentages...
are computed by selecting a base year whose amounts are set equal to 100%.
The amounts of each following year are expressed as a percentage of the base amount.
Trend % = Any year Rs. ÷ Base year Rs.

11. 2. Vertical Analysis...
compares each item in a financial statement to a base number set to 100%.
Every item on the financial statement is then reported as a percentage of that base.

12. 2. Vertical Analysis… 2005 % Revenues Rs.38,303 100.0%
Revenues Rs.38,
Cost of sales ,
Gross profit Rs.18,
Total operating expenses ,
Operating income Rs. 5,
Other income ,
Income before taxes Rs. 7,
Income taxes ,
Net income Rs. 4,

13. 2. Vertical Analysis .. Assets 2005 % Current assets:
Cash Rs. 1,
Receivables net ,
Inventories ,
Prepaid expenses ,
Total current assets Rs.21,
Plant and equipment, net ,
Other assets ,
Total assets Rs.38,

14. 3. Common-size Statements
On the income statement, each item is expressed as a percentage of net sales.
On the balance sheet, the common size is the total on each side of the accounting equation.
Common-size statements are used to compare one company to other companies, and to the industry average.

15. 3. Common-size Statements.. Benchmarking
Percent of Net Sales
Lucent Technologies
MCI
 Cost of goods sold  Operating expenses
 Income tax  Net income

16. 4. Financial Ratios

17. Rationale Behind Ratio Analysis
Financial Statement Analysis
October 2000
Rationale Behind Ratio Analysis
A firm has resources
It converts resources into profits through
production of goods and services
sales of goods and services
Ratios
Measure relationships between resources and financial flows
Show ways in which firm’s situation deviates from
Its own past
Other firms
The industry
All firms-
C.J. Brown, M.M. Dutton and T.A. Rietz

18. Objectives of Ratio Analysis
Financial Statement Analysis
October 2000
Objectives of Ratio Analysis
Standardize financial information for comparisons
Evaluate current operations
Compare performance with past performance
Compare performance against other firms or industry standards
Study the efficiency of operations
Study the risk of operations
Uses
1.      Managers – to help analyze, control, improve a firm’s operations
2.      Credit analysts – to help ascertain a company’s ability to pay its debts
3.      Stock analysts – to determine a company’s efficiency, risk and growth potential
C.J. Brown, M.M. Dutton and T.A. Rietz

19. Financial Statement Analysis
October 2000
Types of Ratios
Financial Ratios:
Liquidity Ratios
Assess ability to cover current obligations
Leverage Ratios
Assess ability to cover long term debt obligations
Operational Ratios:
Activity (Turnover) Ratios
Assess amount of activity relative to amount of resources used
Profitability Ratios
Assess profits relative to amount of resources used
Valuation Ratios:
Assess market price relative to assets or earnings
Liquidity Ratios:
Current Ratio
Quick (Acid Test) Ratio
Cash Ratio
Net Working Capital to Total Assets
Leverage Ratios:
Total Debt Ratio
Debt to Equity Ratio
Equity Multiplier
Long-term Debt Ratio
Times Interest Earned Ratio
Cash Coverage Ratio
Activity (Turnover) Ratios:
Inventory Turnover
Days’ Sales in Inventory
Receivables Turnover
Days’ Sales in Receivables
NWC Turnover
Fixed Asset Turnover
Total Asset Turnover
Profitability Ratios:
Profit Margin
Return on Assets
Return on Equity
Valuation Ratios:
Price to Earnings
Market to Book
C.J. Brown, M.M. Dutton and T.A. Rietz

20. Ratio Classification Measuring Assets Utilization.
Measuring ability to pay current liabilities
Measuring ability to sell inventory and collect receivables
Measuring ability to pay short-term and long-term debt
Measuring profitability
Analyzing stock as an investment

21. Total Assets Turnover
Total assets turnover measures a firm's ability to generate sales from a given level of assets.
A large asset turnover is preferred to a low one.
Total assets turnover is related to three similar ratios
a. Accounts receivable turnover
b. Inventory turnover
c. Fixed asset turnover

22. Fixed Asset Turnover
Measures the relation between investment in long-term or fixed assets (such as property, plant, equipment) and sales.
Efficient use of fixed assets would be associated with high sales.
If fixed assets turn over every four years, then each Rupees invested in fixed assets is generating a quarter of a Rupees in sales per year.
A high turnover is preferred to a low one.

23. Measuring Ability to Pay Current Liabilities
The current ratio measures
the company’s ability to pay
current liabilities with current assets.
Current ratio =
Total current assets ÷ Total current liabilities

24. Measuring Ability to Pay Current Liabilities
The acid-test ratio shows the company’s
ability to pay all current liabilities
if they come due immediately.
Acid-test ratio =
(Cash + Short-term investments
+ Net current receivables)
÷ Total current liabilities

25. Measuring Ability to Sell Inventory
Inventory turnover is a measure
of the number of times the average
level of inventory is sold during a year.
Inventory turnover = Cost of goods sold
÷ Average inventory
Holding inventory is costly because the funds invested in inventory can be used elsewhere.
A high turnover is preferred to a low one.

26. Measuring Ability to Collect Receivables
Accounts receivable turnover measures a company’s
ability to collect cash from credit customers.
Accounts receivable turnover =
Net credit sales ÷ Average accounts receivable
A high turnover is preferred to a low one.

27. Measuring Ability to Collect Receivables
Days’ sales in receivable ratio measures how
many day’s sales remain in Accounts Receivable.
One day’s sales = Net sales ÷ 365 days
Days’ sales in Accounts Receivable =
Average net Accounts Receivable ÷ One day’s sales

28. Measuring Ability to Pay Debt
The debt ratio indicates the proportion
of assets financed with debt.
Total liabilities ÷ Total assets

29. Measuring Ability to Pay Debt
Times-interest-earned ratio
measures the number of times
operating income can cover interest expense.
Times-interest-earned
= Income from operations
÷ Interest expense

30. Measures of Long-Term Risk
Debt-to-equity ratio
(total liabilities)/(total equities)
total equities = total liab. + shareholders’ equity
Percentage of total financing provided by debtors or creditors.
A firm is said to be highly leveraged when this ratio is large.
Cash from operations to total liabilities ratio
Measures the ability of the firm to pay all liabilities from cash without new debt or additional investment.

31. Measures of Long-Term Risk (Cont.)
Interest coverage ratio =
(interest before interest and income tax)
(interest expense)
Number of times interest is covered by income
Indicates the relative protection that operating profitability provides to debtors
Some analysts use cash flows instead of income

32. Profit Margin Ratio
Profit margin ratio measures a firm's ability to control its expenses relative to its sales.
We expect expenses to grow as sales grow, but not as fast.
A high profit margin ratio is preferred to a low one.

33. Return on Equity
The numerator measures return as net income reduced by any payments to preferred shareholders as these dividends are not available to the common shareholder and have not been deducted from net income.
The denominator is the average amount contributed by common shareholders which includes
Common stock at par,
Additional paid in capital, and
Retained earnings.

34. ROCE The first two have been previously defined.
Leverage ratio indicates the relative proportion of capital provided by common shareholders as distinct from that provided by creditors (debtors) or preferred shareholders.

35. Earnings Per Share
EPS does not consider the amount of assets or capital required to generate earnings.
EPS is of limited use in comparing two firms.
For investment purposes, the price to earnings ratio is sometimes used (P/E ratio).
This is the return to the purchaser of a share.
P/E = (market price of a share of stock)/(EPS)
A low P/E is preferred to a high P/E, same earnings at a lower price.

36. Analyzing Stock as an Investment
Financial Statement Analysis
October 2000
Dividend yield shows the percentage
of a stock’s market value returned as
dividends to stockholders each period.
Dividend per share of common
(or preferred) stock ÷ Market price per share
of common (or preferred) stock
C.J. Brown, M.M. Dutton and T.A. Rietz

37. Analyzing Stock as an Investment
Book value per share of common stock
= (Total stockholders’ equity – Preferred equity)
÷ Number of shares of common stock outstanding

38. Summary of Financial Ratios
Financial Statement Analysis
October 2000
Summary of Financial Ratios
Ratios help to:
Evaluate performance
Structure analysis
Show the connection between activities and performance
Benchmark with
Past for the company
Industry
Ratios adjust for size differences
Knowing the absolute level of a single entry on the income statement or balance sheet doesn’t provide sufficient information to evaluate performance. Ratios help by focusing on relationships among entries on the financial statements.
The ratios in the DuPont system show the connection between the firm’s operations, its capital structure and the returns for investors.
Because a firm’s size affects financial statement values, it’s hard to evaluate performance using absolute levels. By controlling for differences in size to make comparisons ratios facilitate the evaluation of a firm’s performance.
C.J. Brown, M.M. Dutton and T.A. Rietz

39. Limitations of Ratio Analysis
Financial Statement Analysis
October 2000
Limitations of Ratio Analysis
A firm’s industry category is often difficult to identify
Published industry averages are only guidelines
Accounting practices differ across firms
Sometimes difficult to interpret deviations in ratios
Industry ratios may not be desirable targets
Seasonality affects ratios
Limitations
1.      Large firms operate different divisions in different industries
a. Difficult to develop meaningful industry averages
b. More useful for small, narrowly focused firms
2.      Firms want to be better than average
a. Attaining average performance not necessarily good
b. Best to focus on industry leaders’ ratios
3.      Inflation may have distorted balance sheets
a. Must consider effects when comparing over time
4.      Seasonal factors distort ratio analysis
a. Use monthly averages for season items such as inventory
5.      Window dressing can make financial statements look better
6.      Different accounting practices can distort comparisons
a. Inventory valuation, depreciation methods
7.      Difficult to generalize whether a ratio is “good” or “bad”
a. High current ratio – strong liquidity or too much cash (nonearning)
8.      Ratios can give “mixed” view of company
a. Analyze net effects of a set of ratios
C.J. Brown, M.M. Dutton and T.A. Rietz

40. 5. Financial Forecasting

41. Ratios and Forecasting
Financial Statement Analysis
October 2000
Ratios and Forecasting
Common stock valuation based on
Expected cashflows to stockholders
ROE and r are major determinants of cashflows to stockholders
Ratios influence expectations by:
Showing where firm is now
Providing context for current performance
Current information influences expectations by:
Showing developments that will alter future performance
Stock prices can be thought of as discounted present value of expected future dividends. Dividends are paid out of earnings. Therefore expectations of future dividends would be based on current earnings (ROE) and sustainable growth rate on earnings.
Ratio analysis can help evaluate current performance as well as firm’s likelihood to be able to sustain performance.
High current ROE that is the result of high Equity Multiplier implies higher risk for stockholders. High ROE that derives from high ROA is less risky and possibly more sustainable.
C.J. Brown, M.M. Dutton and T.A. Rietz

42. Pro Forma Financial Statements
Pro forma refers to a projection of what the financial statements might look like if certain future conditions prevail. Of course, a pro forma statement is only as good as the forecast of the future conditions.
In order to prepare a set of pro forma statements:
1. Project operating revenues
2. Project operating expenses given the level of revenues
3. Project assets required to support the revenues
4. Project financing for the additional assets
5. Project the cost of the financing
6. Project the cash flow statement based on assumptions about the timing of revenues and payments on debt and for expenses.

43. 6. Measure Economic Value
&
Market Value Added

44. MVA & EVA Market Value Added Economic Value Added Each can be viewed
from Total Assets
or Total Equity
The examples in this
set of notes consider
the case of Total Equity

45. MVA & EVA (to Equity Owners)
Market Value Added
Market Value of Equity
minus
Total Money Invested by Equity Owners
(Book Value of Equity)
Total Value created by owning assets which have a greater return than cost of equity
Economic Value Added
Net Income for a Year
minus
Cost of Equity times Book Value of Equity
Value created this year by earning profits in excess of cost of equity capital

46. Information Used in Calculating MVA and EVA (to equity owners)
Equity Information as of the End-of-Period
Net Income for Past Year Rs (known)
Total Equity Book Value Rs.1,080 (known)
Number of Shares (known)
Book Value per Share Rs (calc’ed)
Current Stock Price Rs (assumed)
Assumed Cost of Equity % (assumed)
Constant Future
Dividend Growth Rate % (assumed)

47. MVA Calculation Equity “Capitalization” Rs.2,592
(Rs times 100 shares)
minus
Total Equity Book Value Rs.1,080
Market Value Added Rs.1,512
(Conceptually, this is equal to the summation of all Net Present Values of projects in which the firm has invested.)

48. EVA Calculation Net Income During the Period Rs.200
minus
Period Rs. Cost of Capital Rs.130
Rs.1,000 capital invested (until period end)
times
13% cost of equity
Economic Value Added Rs. 70
(Conceptually, this is the true economic profit created during the year; income above capital cost.)

49. Reconciliation of MVA & EVA
MVA is the present value of expected future EVA’s.
If the past year’s EVA is expected to grow by 8% and the cost of equity is 13%,
MVA = [Rs.70 (1.08)] / [ ] = Rs.1,512
(This is an application of the constant growth valuation model
that is discussed later in the course)

50. Accounting Statement of Cash Flows

51. Statement of Cash Flows
Financial Statement Analysis
October 2000
Statement of Cash Flows
A relatively new financial statement
Intended to highlight major areas from which cash was received and used
Until accountants began reporting the Statement of Cash Flows, financial analysts prepared a “Sources & Uses of Funds” statement based on published balance sheets and income statements
The Statement of Cash Flows categorizes cash flows as follows: --- Cash Flows from Operations --- Cash Flows from Investing Activities --- Cash Flows from Financing Activities
These categories fit well with how finance people view the firm
C.J. Brown, M.M. Dutton and T.A. Rietz

52. Accounting Statement of Cash Flows
Cash Flow from Operating Activities:
Net Income ,220
Depreciation ,000
Total ,220
Increase in Accruals ,000
Increase in Accounts Payable ,600
Increase in Accts. Rec
Increase in Inventory ,800
Net Cash Flow from Operations -73,780
Cash Flow from Investment:
Fixed Asset Increase ,000
Cash Flow from Financing:
Increase in Notes Payable ,000
Increase in Long-term Debt ,180
Common Dividends ,000
Net Cash Flow from Financing 104,180
Total Change in Cash ,600
Operations
Investment
Financing
This balances to
change in Cash

53. Categories in the Statement of Cash Flows
Financial Statement Analysis
October 2000
Categories in the Statement of Cash Flows
Cash Flows from Operations include:
Net Operating Profit After Taxes
Plus adjustments for non-cash expenses
(amortization of depreciation, patents, goodwill, bad debt allowances, etc.)
Changes in Current Assets & Current Liabilities * which move more or less “spontaneously “ with Sales
+ Current Asset = decrease in cash
- Current Asset = increase in cash
+ Current Liability = increase in cash
- Current Liability = decrease in cash
* Exclude Interest Bearing Short Term Debt
Cont…..
C.J. Brown, M.M. Dutton and T.A. Rietz

54. Financial Statement Analysis
October 2000
Cash Flows from Investment Activities include: --- Purchase or sale of long-term operating assets such as plant & equipment --- Acquisitions of other firms or divestitures of divisions --- Ideally separate “Operating Assets” from “Non-Operating Assets”
Cash Flows from Financing Activities include: ---- Sale or retirement of debt ---- Interest expense (after taxes) ---- Sale or retirement of equity securities ---- Dividend payments
Cont…..
C.J. Brown, M.M. Dutton and T.A. Rietz

55. Operating Assets versus Non- Operating Assets
We will not treat any Non- Operating Assets in this set of notes
Non-operating assets include items such as excess marketable securities, Goodwill recorded in an acquisition, deferred taxes, land held for future use, investment in unconsolidated subsidiaries, and so forth

56. Preparation of a Statement of Cash Flows
Financial Statement Analysis
Preparation of a Statement of Cash Flows
October 2000
Published financials will include such a statement.
But many times you will not be working with audited financials or will have to adjust published statements to organize them
in a more meaningful way.
Thus, you should know how to prepare the Statement.
Start by subtracting one balance sheet from another
Arrange balance sheet changes into two columns Sources of Cash Uses of Cash
Be sure the two columns balance (total to the same value)
Rearrange the data into the three categories used in the Statement of Cash Flows
C.J. Brown, M.M. Dutton and T.A. Rietz

57. Source and Use of Funds Statement (Or Changes in Balance Sheets)
Financial Statement Analysis
October 2000
Source and Use of Funds Statement (Or Changes in Balance Sheets)
Change in Fin’l Resources Category
Source Use
Cash ,600 Balancing Item in Statement
Accts. Receivable 50,800 Operating Cash Flow
Inventory 120,800 Operating Cash Flow
Gross Fixed Assets 36,000 Investment Cash Flow
Accum. Depreciation 20,000 Adjust to Net Income
Accounts Payable 29,600 Operating Cash Flow
ST Notes Payable 25,000 Financing Cash Flow
Accruals ,000 Operating Cash Flow
Long Term Debt 101,180 Financing Cash Flow
Ret. Earn.
Net Income 44,220
Dividends ,000 Financing Cash Flow
Total 229, ,600
NOPAT
89,820
To prepare the Statement of Cash Flows, start by calculating the change in each asset, liability and equity item from one year to the next. Each change is placed into a Source or Use of financial resources column. The two columns must add to the same values.
The following rules apply:
Source Use
Asset decrease Asset increase
Debt increase Debt decrease
Equity increase Equity decrease
The asset called “Cash” should be thought of as an asset of “greenbacks”, similar to an Inventory account. If the asset increases, it represents a Use of financial resources. If the asset decreases, it represents a source of financial resources.
The increase in Accumulated Depreciation will usually be due to depreciation expense during the year. Treat it as a Source. Depreciation expense is added to Net Income in order to
Interest AT
45,600
C.J. Brown, M.M. Dutton and T.A. Rietz

58. “Financial” Statement of Free Cash Flows
Cash Flow from Operating Activities:
Net Operating Profit ,820
Depreciation ,000
Total ,820
Increase in Accruals ,000
Increase in Accounts Payable ,600
Decrease in Cash ,600
Increase in Accts. Rec
Increase in Inventory ,800
Net Cash Flow from Operations -22,580
Cash Flow from Investment:
Fixed Asset Increase ,000
Free Cash Flow from Assets -58,580
Cash Flow from Financing:
Increase in Notes Payable ,000
Increase in Long-term Debt ,180
Interest after tax ,600
Common Dividends ,000
Net Cash Flow from Financing 58,580
Operations
Investment
Cash from
Capital
Suppliers

59. Sources of Cash From Capital Suppliers:
Increase in Notes Payable ,000
Increase in Long-term Debt ,180
Interest after tax ,600
Common Dividends ,000
Net Cash Flow from Financing ,580

60. Analysis of the Statement of Cash Flows
Financial Statement Analysis
October 2000
Analysis of the Statement of Cash Flows
Operations drained cash --- NOPAT + Depreciation provided Rs.109, but Inventory & A / R absorbed Rs.171,600 of potential cash inflow
New investment took another Rs.36,000 of cash
This was financed by new debt (mainly Long-Term)
And they continued to pay dividends (Rs.22,000)
This state of affairs can not continue
C.J. Brown, M.M. Dutton and T.A. Rietz

61. Implications of the Statement of Cash Flows
Financial Statement Analysis
October 2000
Implications of the Statement of Cash Flows
There might be a problem with excess Inventory & Accounts Receivable
Unless sales increase substantially to warrant higher Inventory & Receivables, they need to be reduced
Notice also that Inventory & Receivables were financed with long-term debt, is there a problem with this?
C.J. Brown, M.M. Dutton and T.A. Rietz