1. ANALYSIS OF FINANCIAL STATEMENTS
Chapter 11
ANALYSIS OF FINANCIAL STATEMENTS

2. Chapter 11 Questions Questions to be answered:
What are the major financial statements provided by firms and what specific information does each of them contain?
Why do we use financial ratios to examine the performance of a firm, and why is it important to examine performance relative to the economy and to a firm’s industry?

3. Chapter 11 Questions
What are the major categories for financial ratios and what questions are answered by the ratios in these categories?
What specific ratios help determine a firm’s internal liquidity, operating performance, risk profile, and growth potential?
How can the DuPont analysis help evaluate a firm’s past and future return on equity?

4. Chapter 11 Questions
What is a quality balance sheet or income statement?
Why is financial statement analysis done if markets are efficient and forward-looking?
What major financial ratios help analysts in the following areas: stock valuation, estimating and evaluating systematic risk, predicting the credit ratings on bonds, and predicting bankruptcy?

5. Analyzing Financial Statements
We will be considering asset valuation.
Financial asset values are a function of two variables:
Discount rate ( the required rate of return)
Expected future cash flows
Financial statement analysis can be useful in estimating both of these valuation inputs.

6. Major Financial Statements
Corporate shareholder annual and quarterly reports must include:
Balance sheet
Income statement
Statement of cash flows
Reports filed with Securities and Exchange Commission (SEC)
10-K and 10-Q

7. Generally Accepted Accounting Principles
GAAP are formulated by the Financial Accounting Standards Board (FASB)
Provides some flexibility of accounting principles
Can be good for firms in different situations
Can represent a challenge for analysis
Financial statements footnotes must disclose which accounting principles are used by the firm

8. Balance Sheet
Shows resources (assets) of the firm and how it has financed these resources
Indicates current and fixed assets available at a point in time
Financing is indicated by its mixture of current liabilities, long-term liabilities, and owners’ equity

9. Income Statement
Contains information on the profitability of the firm during some period of time
Indicates the flow of sales, expenses, and earnings during the time period

10. Statement of Cash Flows
Integrates the information on the balance sheet and income statement
Shows the effects on the firm’s cash flow of income statement items and changes in various items on the balance sheet
Three sections show cash flows from
Operating activities
Investing activities
Financing activities

11. Alternative Measures of Cash Flow
Cash flow from operations
Traditional cash flow equals net income plus depreciation expense and deferred taxes
Also adjust for changes in operating assets and liabilities that use or provide cash
Free cash flow recognizes that some investing and financing activities are critical to ongoing success of the firm
Modifies cash flow from operations to reflect necessary capital expenditures and projected divestitures

12. Alternative Measures of Cash Flow
EBITDA
Earnings Before Interest, Taxes, Depreciation, and Amortization
A more generous measure of operating earnings, since all of these items are added back
Perhaps a somewhat questionable measure of actual operating performance

13. Purpose of Financial Statement Analysis
Evaluate management performance in
Profitability
Efficiency
Risk
Although financial statement information is historical, it is used to project future performance

14. Analysis of Financial Ratios
Ratios can often be more informative that raw numbers
Puts numbers in perspective with other numbers
Helps control for different sizes of firms
Ratios provide meaningful relationships between individual values in the financial statements

15. Importance of Relative Financial Ratios
In order to make sense of a ratio, we must compare it with some appropriate benchmark or benchmarks
Examine a firm’s performance relative to:
The aggregate economy
Its industry or industries
Its major competitors within the industry
Its own past performance (time-series analysis)

16. Comparing to the Aggregate Economy
Most firms are influenced by economic expansions and contractions in the business cycle
Analysis helps you estimate the future performance of the firm during subsequent business cycles

17. Comparing to the Industry Norms
Most popular comparison
Industries affect the firms within them differently, but the relationship is always significant
The industry effect is strongest for industries with homogenous products
Can also examine the industry’s performance relative to aggregate economic activity

18. Comparing to the Firm’s Major Competitors
Industry averages may not be representative
A firm may operate in several distinct industries
Several approaches:
Select a subset of competitors for the comparison group
Construct a composite industry average from the different industries in which the firm operates

19. Comparing to the Firm’s Own Past Performance
Determine whether it is progressing or declining
Helpful for estimating future performance
Consider trends as well as averages over time

20. Five Categories of Financial Ratios
Common size statements
Internal liquidity (solvency)
Operating performance
Operating efficiency
Operating profitability
Risk analysis
Business risk
Financial risk
External liquidity risk
Growth analysis

21. 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

22. 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

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

24. Evaluating Internal Liquidity
Cash ratio relates cash (ultimate liquid asset) to current liabilities

25. Evaluating Internal Liquidity
Receivables turnover examines the management of accounts receivable
Receivables turnover can be converted into an average collection period

26. Evaluating Internal Liquidity
Inventory turnover relates inventory to sales or cost of goods sold (CGS)
Given the turnover values, you can compute the average inventory processing time

27. Evaluating Internal Liquidity
Cash conversion cycle combines information from the receivables turnover, inventory turnover, and accounts payable turnover
CCC = Receivables Collection Period
+ Inventory Processing Period
- Payables Payment Period

28. Evaluating Operating Performance
Ratios that measure how well management is operating a business
Operating efficiency ratios
Examine how management uses its assets to generate sales; considers the relationship between various asset categories and sales
Operating profitability ratios
Examine how management is doing at controlling costs so that a large proportion of the sales dollar is converted into profit

29. Operating Efficiency Ratios
Total asset turnover ratio indicates the effectiveness of a firm’s use of its total asset base to produce sales

30. Operating Efficiency Ratios
Net fixed asset turnover reflects utilization of fixed assets
This number can look temporarily bad if the firm has recently added greatly to its capacity in anticipation of future sales

31. Operating Profitability Ratios
Operating profitability ratios measure
The rate of profit on sales (profit margin)
The percentage return on capital

32. Operating Profitability Ratios
Gross profit margin measures the rate of return after cost of goods sold
What proportion of the sales dollar is left after cost of goods sold?
Is the firm buying inputs (inventory and direct labor) at good prices?

33. Operating Profitability Ratios
Operating profit margin measures the rate of profit on sales after operating expenses
Operating profit is sometimes called Earnings before interest and taxes (EBIT)
Operating income can be thought of as the “bottom line” from operations

34. Operating Profitability Ratios
Net profit margin relates net income to sales
Shows the combined effect of operating profitability and the firm’s financing decisions (since net income is after interest and tax payments)

35. Common Size Income Statement
Since Net Sales is in the denominator of all of the three previous ratios, the common size income statement gives all of these ratios at once
It also allows us to focus on any categories of expenses that are out of line with the appropriate benchmark

36. Operating Profitability Ratios
Return on total capital relates the firm’s earnings to all capital invested in the business

37. Operating Profitability Ratios
Consideration of Lease Obligations
Leases for assets are economically similar to debt obligations, but have different accounting treatment
May want to capitalize operating leases in order to get a more accurate measure of assets and financing
Should also consider the implied interest and depreciation for leases when including the impact of leases on the Return on total capital

38. Operating Profitability Ratios
Return on owner’s equity (ROE) indicates the rate of return earned on the capital provided by the stockholders after paying for all other capital used

39. Operating Profitability Ratios
Return on owner’s equity (ROE) can be computed for the based only on the common shareholder’s equity
Deducts preferred dividends, which are a priority claim on net income

40. Operating Profitability Ratios
The DuPont System divides ROE into several ratios that collectively equal ROE while individually providing insight

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

42. Operating Profitability Ratios
An extended DuPont System provides additional insights into the effect of financial leverage on the firm and pinpoints the effect of income taxes on ROE

43. Risk Analysis
Risk analysis examines the uncertainty of income for the firm and for an investor
Total firm risks can be decomposed into two basic sources:
Business risk: The uncertainty in a firm’s operating income, highly influenced by industry factors
Financial risk: The added uncertainty in a firm’s net income resulting from a firm’s financing decisions (primarily through employing leverage).
External liquidity analysis considers another aspect of risk from an investor’s perspective

44. Business Risk Variability of the firm’s operating income over time
Can be measured by calculating the standard deviation of operating income over time or the coefficient of variation
In addition to measuring business risk, we want to explain its determining factors.

45. Business Risk Two primary determinants of business risk
Sales variability
The main determinant of earnings variability
Cost Variability and Operating leverage
Production has fixed and variable costs
Greater fixed production costs cause greater profit volatility with changes in sales
Fixed costs represent operating leverage
Greater operating leverage is good when sales are high and increasing, but bad when sales fall

46. Financial Risk
Interest payments are deducted before we get to net income
These are fixed obligations
Similar to fixed production costs, these lead to larger earnings during good times, and lower earnings during a business decline
Fixed financing costs are called financial leverage
The use of debt financing increases financial risk and possibility of default while increasing profitability when sales are high

47. Financial Risk
Two sets of financial ratios help measure financial risk
Balance sheet ratios
Earnings or cash flow available to pay fixed financial charges
Acceptable levels of financial risk depend on business risk
A firm with considerable business risk should likely avoid lots of debt financing

48. Financial Risk Proportion of debt (balance sheet) ratios
Long-term debt can be related to:
Equity (L-t D/Equity)
How much debt does the firm employ in relation to its use of equity?
Total Capital [L-t D/(L-t D +Equity)]
How much debt does the firm employ in relation to all long-term sources of funds?
Total debt can be related to:
Total Capital [Total Debt/(Ttl. Liab.–Non-int. Liab.)]
Assessment of overall debt load, including short-term

49. Financial Risk Earnings or Cash Flow Ratios
Relate operating income (EBIT) to fixed payments required from debt obligations
Higher ratio means lower risk

50. Financial Risk Interest Coverage or Times Interest Earned Ratio
Measures the number of times Interest payments are “covered” by EBIT
Interest Coverage = EBIT/Interest Expense
May also want to calculated coverage ratios that reflect other fixed charges
Lease obligations (Fixed charge coverage)

51. Financial Risk Cash flow ratios
Fixed financing costs such as interest payments must be paid in cash, so these ratios use cash flow rather than EBIT to assess the ability to meet these obligations
Relate the flow of cash available from operations to:
Interest expense
Total fixed charges
The face value of outstanding debt

52. External Liquidity Risk
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

53. External Liquidity Risk
The most important factor of external market liquidity is the dollar value of shares traded
This can be estimated from the total market value of outstanding securities
It will be affected by the number of security owners
Numerous buyers and sellers provide liquidity

54. Analysis of Growth Potential
Want to determine sustainable growth potential
Important to both creditors and owners
Creditors interested in ability to pay future obligations
For owners, the value of a firm depends on its future growth in earnings, cash flow, and dividends

55. Determinants of Growth
Sustainable Growth Model
Suggests that the sustainable growth rate is a function of two variables:
What is the rate of return on equity (which gives the maximum possible growth)?
How much of that growth is put to work through earnings retention (rather than being paid out in dividends)?
g = ROE x Retention rate
The retention rate is one minus the firm’s dividend payout ratio
Anything that impacts ROE would also be a determinant of future growth

56. Determinants of Growth
ROE (recall the DuPont equation) is a function of
Net profit margin
Total asset turnover
Financial leverage (total assets/equity)

57. Analysis of Non-U.S. Financial Statements
Statement formats will be different
Differences in accounting principles
Ratio analysis will reflect local accounting practices

58. The Quality of Financial Statements
“Quality financial statements” reflect reality rather than use accounting tricks or one-time adjustments to make things look better than they are

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

60. 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

61. 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

62. Uses of Financial Ratios
Stock valuation
Identification of corporate variables affecting a stock’s systematic risk (beta)
Assigning credit quality ratings on bonds
Predicting insolvency (bankruptcy) of firms

63. Financial Ratios and Stock Valuation Models
Stock valuation often considers discounted cash flow analysis
Estimate cash flows
Estimate an appropriate discount rate
A number of financial ratios can be useful in arriving at estimates for each of these inputs
Price ratio analysis for a stock
Sometimes we estimate the value of a stock through various price ratios such as P/E
Would need to estimate variables such as expected growth rate of earnings and dividends

64. Financial Ratios and Systematic Risk
A firm’s systematic risk (as measured by beta) is related to a number of financial statement variables

65. Financial Ratios and Bond Ratings
Changes in bond ratings are linked to changes in various financial statement variables
Predicting such changes in ratings before they occur can increase the return on a bond or stock portfolio

66. Financial Ratios and Insolvency (Bankruptcy)
Certainly, analysts and investors are concerned with the possibility of bankruptcy
A number of variables have a rather strong relationship to the bankruptcy experience of firms in the past
Can use financial statement analysis to identify firms where insolvency is a likely outcomes

67. Limitations of Financial Ratios
Always consider relative financial ratios
Accounting treatments may vary among firms, especially among non-U.S. firms
Firms may have have divisions operating in different industries making it difficult to derive industry ratios
Are the results consistent?
Ratios outside an industry range may be cause for concern