Financial Statement Analysis

Financial Statement Analysis
October 2000 Financial Statement Analysis Curriculum designed for use with the Iowa Electronic Markets by Cynthia J. Brown Marilyn M. Dutton Thomas A. Rietz As a general note, it is easy to get lost by focusing on the calculation of ratios. The students probably need more help in interpretation of ratios. Instruction should include both help with calculations and guidance in interpretation. C.J. Brown, M.M. Dutton and T.A. Rietz

Financial Statement Analysis: Lecture Outline
October 2000 Financial Statement Analysis: Lecture Outline Review of Financial Statements Ratios Types of Ratios Examples The DuPont Method Ratios and Growth Summary Strengths Weaknesses Ratios and Forecasting Financial Statements summarize the results of the firm’s activities over the accounting period. Ratios provide a useful way to analyze financial statements and evaluate the firm’s performance over the period. Focusing on the ratios in the DuPont system helps structure the analysis and show the relationship between the firm’s operations, its capital structure and its profitability for investors. Using ratio analysis along with predictions about sustainable growth rates can help us predict future performance of the firm. C.J. Brown, M.M. Dutton and T.A. Rietz

October 2000 Stock Price Expected Cashflows Market Conditions NPV MVA EVA Timing of Cashflows Stock Price When investors purchase a share of stock, they are buying ownership in the company. This ownership entitles them to share in the company’s profits paid out in the form of dividends. The price investors are willing to pay for the stock is a function of the size of the dividends they expect to receive. The time value of money also plays a role. How long they have to wait to receive the dividends also affects the price investors are willing to pay for the stock. The degree to which they are uncertain about the size of the dividend will also affect how much they are willing to pay. All else equal, a sure payment is more attractive than an uncertain payment and investors will pay more for the stock. Investors have to make educated guesses about the future. Risk of Cashflows C.J. Brown, M.M. Dutton and T.A. Rietz

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, 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

October 2000 Financial Statements Balance Sheet Income Statement Cashflow Statement Statement of Retained Earnings 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

October 2000 Sources of Data Annual reports Via mail, SEC or company websites Published collections of data e.g., Dun and Bradstreet or Robert Morris Investment sites on the web Examples Annual Report Used by investors to help form expectations about future earnings and dividends Verbal Section Explain why things turned out the way they did Describes firms operating results during past year Discusses new developments that will affect future earnings Financial Statements Report what actually happened to assets, earnings, dividends Balance sheet Income statement Statement of retained earnings Statement of cash flows Advantages and Disadvantages of Data Sources The advantage of Annual reports is that give a great deal of information. They are available through the web now. The disadvantage is that they are not in a standard format and they are frequently affected by subtle differences in accounting rules. The advantage of published data on ratios is that they standardize the financial statements and compute ratios based on this information. The disadvantage is that this may hide important factors and the information my be far from current. The advantage of investment sites on the web is that they have the most current data. Some of them even standardize statements (e.g., Microsoft’s MoneyCentral). Of course, this has advantages and disadvantages. C.J. Brown, M.M. Dutton and T.A. Rietz

October 2000 The Main Idea Value for the firm comes from cashflows Cashflows can be calculated as: (Revt - Costt - Dept)x(1-t) + Dept —OR— (Revt - Costt)x(1-t) + txDept —OR— Revtx(1-t) - Costtx(1-t) + txDept The main idea is that cashflows are what create value for a company. Cashflows do not appear directly in the income statement because: Some income statement items are not actually cashflows (e.g., depreciation and amortization). Some cashflow items do not appear in the income statement (e.g., changes in working capital). Nevertheless, the income statement serves as the basis for determining cashflows and clearly shows how various factors (e.g., COGS) influence cashflows. So we will start with the income statement and make adjustments as necessary. The basis will be that net income is sales minus costs minus depreciation. We are taxed on this number. But, depreciation needs to be added back in because it is not an actual cash outflow. C.J. Brown, M.M. Dutton and T.A. Rietz

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

An Example: Dell Abbreviated Balance Sheet
Financial Statement Analysis October 2000 An Example: Dell Abbreviated Balance Sheet Assets: Current Assets: $7,681.00 Non-Current Assets: $3,790.00 Total Assets: $11,471.00 Liabilities: Current Liabilities: $5,192.00 LT Debt & Other LT Liab.: $971.00 Equity: $5,308.00 Total Liab. and Equity: $11,471.00 Dell’s Balance Sheet: Assets the firm owns total more that $11 billion** , more short-term assets than long-term assets like plant and equipment. Those assets were purchased with money that came mainly from equity and short-term borrowing. Relatively little long-term debt. C.J. Brown, M.M. Dutton and T.A. Rietz

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

An Example: Dell Abbreviated Income Statement
Financial Statement Analysis October 2000 An Example: Dell Abbreviated Income Statement Sales $25,265.00 Costs of Goods Sold -$19,891.00 Gross Profit $5,374.00 Cash operating expense -$2,761.00 EBITDA 2,613.00 Depreciation & Amortization -$156.00 Other Income (Net) -$6.00 EBIT $2,451.00 Interest -$0.00 EBT $2,451.00 Income Taxes -$785.00 Special Income/Charges -$194.00 Net Income (EAT) $1,666.00 Dell had more than $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

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

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

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

Liquidity Ratio Examples: Dell
Financial Statement Analysis October 2000 Liquidity Ratio Examples: Dell Current Ratio: Quick (Acid Test) Ratio: Used to study ability to cover current obligations Can firm raise cash to pay its current and upcoming bills on time? Basic Formulation: Liquid asset measures include: Current Assets Current Assets minus Inventories If industry average is 3.5, then Dell has fewer current assets per dollar of current liabilities than the norm If acid test ratio > 1, then Dell can meet all current liabilities even if sales cease C.J. Brown, M.M. Dutton and T.A. Rietz

Ratio Comparison: Current Ratio
Financial Statement Analysis October 2000 Ratio Comparison: Current Ratio Comparison of Dell with industry shows both in the 1.5 to 2 range. If all current assets were liquidated at book value, cash would be 1.5 to 2 times value of current obligations. Dell appears to be within industry norms for current ratio. C.J. Brown, M.M. Dutton and T.A. Rietz

Leverage Ratio Examples: Dell
Financial Statement Analysis October 2000 Leverage Ratio Examples: Dell Debt Ratio: Measure ability to cover long term debt How much debt has the firm issued? Can the firm afford to pay its long term interest and principal obligations? Basic formulation: Debt and debt service measures include: Total liabilities Long term debt Annual interest expenses Asset, profit or cash flow measures include: Total assets Total capitalization EAT, Profit... 1-Debt Ratio is fraction of firm owned by equity holders If industry average is 2.5 then revenues for Dell relative to interest expenses exceed industry norm C.J. Brown, M.M. Dutton and T.A. Rietz

Ratio Comparison: Debt Ratio
Financial Statement Analysis October 2000 Ratio Comparison: Debt Ratio Dell has employed slightly more debt than the industry norm over the last four years. Nearly 80% debt in January 1997. This possibly reflects rise and fall in amount of current assets on balance sheet. Note connection between pattern of current ratio and pattern of debt ratio. C.J. Brown, M.M. Dutton and T.A. Rietz

Profitability Ratio Examples: Dell
Financial Statement Analysis October 2000 Profitability Ratio Examples: Dell Return on Assets (ROA): Return on Equity (ROE): Used to study operating profitability. How do profits compare to sales or assets? Basic Formulation: Profit measures include: Sales less costs Net Income Income Available to Common Stock Holders Sales/Asset measures include: Sales Total Assets Common Equity NOTE: Some books use: If yours does, use these equations AND adjust the DuPont Method accordingly by adding the the debt burden. C.J. Brown, M.M. Dutton and T.A. Rietz

Profitability Ratio Examples: Dell
Financial Statement Analysis October 2000 Profitability Ratio Examples: Dell Net Profit Margin: Retention Ratio Used to study operating profitability. How do profits compare to sales or assets? Basic Formulation: Profit measures include: Sales less costs Net Income Income Available to Common Stock Holders Sales/Asset measures include: Sales Total Assets Common Equity C.J. Brown, M.M. Dutton and T.A. Rietz

October 2000 Ratio Comparison: ROE Compare Dell to industry norm. Both start 1996 with fairly similar ROE but during the next two years Dell’s ROE soars above industry. What contributed to Dell’s outstanding performance for shareholders relative to the industry? Recall: ROE = ROA x Equity Multiplier Equity Multiplier rises when debt ratio rises. Dell’s debt ratio rose above industry norm during this period. Part of Dell’s superior ROE explained by higher debt ratio. ROA must also play a role. C.J. Brown, M.M. Dutton and T.A. Rietz

October 2000 Ratio Comparison: ROA Dell’s superior ROE driven by higher than norm ROA. Note comparison to industry. Dell maintains consistently higher ROA than norm throughout the period. Also subject to pressures affecting all firms in its industry - rise then decline in ROA. Able to withstand some of these pressures - ends period better off than at beginning, unlike the average firm in the industry. How did Dell achieve such an outstanding performance on ROA? Recall that ROA is affected by two other ratios: ROA = Profit Margin x Asset Turnover C.J. Brown, M.M. Dutton and T.A. Rietz

Ratio Comparison: Profit Margin
Financial Statement Analysis October 2000 Ratio Comparison: Profit Margin Profit Margin measures the firm’s ability to control expenses. An 8% profit margin for Dell in 1999 says out of each dollar of sales, Dell spent 92 cents on expenses while the industry average was more than 97 cents. Over the four years Dell consistently did a better job of controlling expenses than the average firm in the industry. And it got better and better at containing expenses while the average firm in the industry did worse. Dell’s superior Return on Assets is in part the result of better ability to control expenses. C.J. Brown, M.M. Dutton and T.A. Rietz

Activity (Turnover) Ratio Examples: Dell
Financial Statement Analysis October 2000 Activity (Turnover) Ratio Examples: Dell Total Asset Turnover Ratio: Inventory Turnover Ratio: Profitability is also affected by the firm’s ability to use its assets efficiently. Used to study operating efficiency. How do sales compare to the assets used in production? Basic Formulation: Assets include: All Assets Inventories Accounts Receivable If industry average is 1.25, then Dell gets more sales per dollar invested in assets than typical in the industry If industry average is 2, then Dell turns its inventory over more times on average than industry (Few assets are tied up in inventories) C.J. Brown, M.M. Dutton and T.A. Rietz

Ratio Comparison: Asset Turnover
Financial Statement Analysis October 2000 Ratio Comparison: Asset Turnover A comparison of Dell’s Asset Turnover to that of the industry shows Dell outperformed the industry norm in that area also. In January 1999 every dollar of assets generated $2.65 in sales for Dell while the average for all firms in the industry was just $2 of sales per dollar invested in assets. This efficient use of assets also contributed to the superior performance in ROA. C.J. Brown, M.M. Dutton and T.A. Rietz

October 2000 The DuPont System Method to breakdown ROE into: ROA and Equity Multiplier ROA is further broken down as: Profit Margin and Asset Turnover Helps to identify sources of strength and weakness in current performance Helps to focus attention on value drivers DuPont Chart and Equation - Tie the Ratios Together Shows how profit margin, asset turnover ratio, and equity multiplier determine ROE Shows how expense control (profit margin), efficient use of assets in production (asset turnover) and capital structure (equity multiplier) affect return on equity. Ties together all aspects of firm - production and financing. C.J. Brown, M.M. Dutton and T.A. Rietz

October 2000 The DuPont System C.J. Brown, M.M. Dutton and T.A. Rietz

October 2000 The DuPont System Notice that using more debt (and less equity) to finance assets raises the Equity Multiplier. This has two effects for stockholders. The Equity Multiplier acts as a lever to magnify the effects of ROA on returns for stockholders. If ROA is positive, ROE is a larger positive value, but if ROA is negative ROE is a larger negative. Raising the s magnifying effect also raises the risk for stockholders. C.J. Brown, M.M. Dutton and T.A. Rietz

October 2000 The DuPont System Return on Assets is affected by two areas of operations. The Profit Margin measures the degree to which the firm controls expenses. Since expenses comprise the difference between Sales and Net Income, lowering the expenses taken out of each dollar of sales raises the Profit Margin. At the same time, Return on Assets can be raised by producing sales by using fewer assets. Asset Turnover measures the dollar of sales produced with each dollar invested in assets. This is often thought of as sales volume. Different industries achieve ROA in different ways. Some have low profit margins but high volume, e.g. grocery stores. Others have lower volume but are able to maintain higher profit margins, e.g. car dealerships. C.J. Brown, M.M. Dutton and T.A. Rietz

October 2000 The DuPont System C.J. Brown, M.M. Dutton and T.A. Rietz

The DuPont System: Dell
Financial Statement Analysis October 2000 The DuPont System: Dell Dells ROE 31.39% is higher than the industry standard (24.1% average over the past 4 years). Where is Dell making these high profits? Dell’s ROE comes from: Dell’s profit margin is 6.59% The industry average over the preceding 4 years is only 3.69%. So, Dell is nearly twice as efficient as the industry average in generating profits from its sales. Dell’s sales-to-assets ratio is 2.20. The industry average over the preceding 4 years is 2.05. So, Dell is about average is generating sales from its assets. Dell’s equity multiplier is 2.16. The industry average over the preceding 4 years is 2.50. So, Dell is a little below average in its equity multiplier (using a little more equity and a little less debt than an average company in the industry.) Thus, we can conclude that Dell’s profitability comes from it’s operating efficiency! C.J. Brown, M.M. Dutton and T.A. Rietz

A Note on Sustainable Growth and Stock Returns
Financial Statement Analysis October 2000 A Note on Sustainable Growth and Stock Returns In the long run Sustainable growth and long run capital gains (g) = ROE x r Recall the relationship between stock returns (r), capital gains (g) and forward dividend yields (D1/P0): r = g + D1/P0 = g + Do(1+g)/P0 Note: r & g must be quarterly if D is quarterly and annual if D is annual The intuition here is simple: The assets that a firm has generates income. The returns to the equity assets of the firm are given by ROE. The retention ratio shows how much of the ROE is re-invested in new equity. This makes equity grow at the rate ROExr. A bank account example usually helps. Suppose you have $1000 in a bank account at 10% interest and withdraw 75% of the interest each year…thus re-investing 25%. How fast does your bank account, interest and withdrawal rate grow? Answer: 0.10x0.25 = 2.5% per year. To see this calculate the numbers: Year Initial Principle Interest Withdrawal Final Principle 1 $ $100 $ $ 2 $ $ $ $ 3 $ $ $ $ The growth each year in principle, interest and withdrawals is 2.5%! C.J. Brown, M.M. Dutton and T.A. Rietz

Example: Predicted Sustainable Growth for Dell
Financial Statement Analysis October 2000 Example: Predicted Sustainable Growth for Dell Based on the most recent numbers: ROE = 31.39% & r = 100% g = x 1 = 31.39% r = /P = 31.39% Based on 5 year averages: ROE = 51.94% & r = 100% g = x 1 = 51.94% r = /P = 51.94% If Dell continues with its level of ROE and re-investment, it can sustain astonishing growth rates. However, how long will Dell’s demand allow it to keep growing at this rate? C.J. Brown, M.M. Dutton and T.A. Rietz

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

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

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

How Might Ratios Help Me on the IEM?
Financial Statement Analysis October 2000 How Might Ratios Help Me on the IEM? Analysis of AAPL, IBM and MSFT, and comparisons to the S&P500 companies can help to: Assess the (absolute and relative) financial state of each company Show each company’s strengths and weaknesses Predict sustainable growth rate Combined with current information, this can help to: Assess likely future performance Predict future valuation and earnings growth Predict returns C.J. Brown, M.M. Dutton and T.A. Rietz

Financial Statement Analysis

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