1. Analyzing and Interpreting Financial Statements
Module 3
Analyzing and Interpreting Financial Statements

2. Common Questions that F/S Analysis Can Help To Answer
Creditor
Investor
Manager
Can the company pay the interest and principal on its debt? Does the company reply too much on non-owner financing?
Does the company earn an acceptable return on invested capital? Is the gross profit margin growing or shrinking? Does the company effectively use non-owner 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?

3. Question?
Is a Net Income of $100,000 good?

4. 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
Level I – RNOA and LEV
Level II – Profit Margins and Turnover
Level III – GPM, OEM, ART, INVT, APT, etc.
As well as Liquidity and Solvency Measures

5. Profitability Analysis
Return on Assets (ROA):
ROA = Net Income / Average Assets
For example, if we invest $100 in a savings account yielding $3 at year-end, the return on assets is 3%.

6. Disaggregating Return on Assets

7. Profit Margin, Asset Turnover, and Return on Assets for Selected Industries

8. Operating vs. Nonoperating
Operating expenses are the usual and customary costs that a company incurs to support its main business activities
Nonoperating expenses relate to the company’s financing and investing activities

9. Transitory vs. Core
Transitory items are one-time events (e.g., not likely to recur)
Core items are likely to recur (persist) and are, therefore, more relevant for company valuation

10. Operating/Nonoperating vs. Core/Transitory

11. Analysis Structure

12. Return on Equity – Level 1
Return on equity (ROE) is computed as:
ROE = Net Income / Average Equity

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

14. Financial Leverage and Risk
LEV is the other component of ROE
Is Debt a bad thing?
Given that increases in financial leverage increase ROE, why are all companies not 100% debt financed?

15. Leverage and Income Variability

16. Level II Analysis – Margin and Turnover

17. Level 3 Analysis — Disaggregation of Margin and Turnover

18. Gross Profit Margin 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.

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

20. 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.
As turnover increases, there is greater cash inflow as cash outflow for assets to support the current sales volume is reduced.

21. Accounts Receivable Turnover (ART)

22. Inventory Turnover (INVT)

23. Accounts Payable Turnover (APT)

24. 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.
Solvency refers to the ability to meet obligations; primarily obligations to creditors, including lessors.

25. Current and Quick Ratio

26. Solvency Ratios

27. Flow Ratios

28. Vertical and Horizontal Analysis

29. Vertical and Horizontal Analysis

30. Limitations of Ratio analysis