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									Financial Statement Analysis
                Objectives
• Review the components of the financial
  statement package.
• Discuss the information contained in the
  financial statements and how it can be used to
  evaluate a firm.
• Discuss the types of questions can financial
  ratios answer.
• Discuss the relationship between the notion of
  market efficiency and financial statement
  analysis.

Tom Rourke        FINA 4397 - Financial        2
                   Statement Analysis
             Introduction to Financial
                Statement Analysis
• A major source of information regarding a a
  firm’s operating performance and its resources
  is the firm’s financial statement package.
• Analyzing a set of financial statements involves
  using ratios of key financial statement items and
  other tools to gain insight into the profitability
  and risk of a firm.
• Financial statement analysis can help us to
  better understand the business risk and the
  financial risk of a firm.

Tom Rourke           FINA 4397 - Financial         3
                      Statement Analysis
              Principal Financial
                  Statements
• Financial statements are intended to provide
  information on the operating performance and
  financial health of a business during a specified
  period of time.
• In the US, financial statements are required to
  adhere to GAAP (although GAAP does allow
  some flexibility).
    – One goal is to make the financial statements of one
      firm comparable across time and to the financial
      statements of other firms.

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                       Statement Analysis
             Principal Financial
             Statements, cont.
• GAAP requires firms to present balance sheets
  for the two most recent years and income
  statements and statements of cash flows for the
  three most recent years in a set of financial
  statements.
• In addition, firms are required to present notes to
  the financial statements that provide information
  on the accounting methods used by the firm to
  construct the financial statements.

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                     Statement Analysis
               The Balance Sheet
• The balance sheet is a statement of financial
  position that presents details of the resources of
  a firm and the claims on those resources as of
  a specific point in time (i.e., on March 31,
  20XX).
    – It is a “static” statement.
• The asset side of a balance sheet reports the
  effects of a firm’s past investment decisions
  while the liabilities and shareholders’ equity side
  reports the effects of a firm’s past financing
  decisions.
Tom Rourke                FINA 4397 - Financial     6
                           Statement Analysis
             The Balance Sheet, cont.
• The balance sheet               is         governed   by   the
  accounting identity:
 Assets  Liabilitie s  Shareholde rs' Equity
• Assets are resources that have the potential for
  providing a firm with future economic benefits.
• Liabilities are obligations to pay for benefits or
  services received in the past.
• Shareholders’ Equity represents a residual claim
  on the firm (in book value terms).
Tom Rourke           FINA 4397 - Financial                     7
                      Statement Analysis
             The Balance Sheet, cont.
• It is important to note that most (if not all in some
  cases) assets and liabilities are reported on a
  firm’s balance sheet are at historical cost (less
  some adjustments).
• It is very rare that historical cost equals market
  value.
• Examples:
    – Machinery: historical cost less depreciation
    – Accounts Receivables: historical value less an
      allowance for doubtful accounts
    – Inventory: lower of cost or market
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                      Statement Analysis
             The Balance Sheet, cont.
• It is also important to note that the balance sheet
  may not report all assets and liabilities of a firm.
    – Only assets and liabilities meeting certain criteria set
      out by GAAP are required to be reported on the
      balance sheet.
    – The footnotes are a source of information for these
      other off-balance sheet “assets” and “liabilities.”




Tom Rourke              FINA 4397 - Financial                9
                         Statement Analysis
             The Balance Sheet –
                   Assets
• Assets are resources under a firm’s control that
  have the potential to provide the firm with future
  economic benefit(s).
    – i.e., the ability to generate future cash inflows
      (accounts receivables, inventories, etc.) or decrease
      future cash outflows (i.e., prepayments, etc.)
• Assets are usually presented in order of their
  “liquidity” (cash, cash equivalents, accounts
  receivables, inventories, etc.).



Tom Rourke             FINA 4397 - Financial             10
                        Statement Analysis
             The Balance Sheet –
                Assets, cont.
• Assets can be
    – Monetary Assets
       • cash, cash receivables, etc.
       • Monetary assets are reported at the amount of
         cash the firm expects to receive in the future.
    – Non-monetary
       • inventories, PP&E, etc.
       • GAAP generally requires reporting non-monetary
         assets at their historical cost (historical cost is
         objective and verifiable).

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                         Statement Analysis
             The Balance Sheet –
                Assets, cont.
• Assets can be (cont.)
    – Current Assets
       • Cash and other assets (A/R, inventory,
         prepayments, etc.) expected to be converted into
         cash, sold, or consumed either in one year or in
         the operating cycle, whichever is longer.
    – Non-current/Long-term Assets
       • Assets not classified as current (PP&E, some
         prepayments, etc.).



Tom Rourke            FINA 4397 - Financial            12
                       Statement Analysis
             The Balance Sheet –
                  Liabilities
• A liability represents a firm’s obligation to make
  payments of cash, goods, or services in a
  reasonably definite amount at a reasonably
  definite time in the future for benefits or services
  received in the past.
• Liabilities are generally monetary (require a
  payment of a fixed amount of cash) but can be
  non-monetary.


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                      Statement Analysis
             The Balance Sheet –
               Liabilities, cont.
• Liabilities can be
    – Current Liabilities
       • Obligations whose liquidation is reasonably
         expected to require the use of existing resources
         classified as current assets or the creation of other
         current liabilities.
    – Non-current/Long-term Liabilities
       • Obligations not classified as current.




Tom Rourke              FINA 4397 - Financial               14
                         Statement Analysis
             The Balance Sheet –
             Shareholders’ Equity
• The shareholders’ equity in a firm is the firm’s
  owners’ residual interest or claim on the firm.
• The accounting identity can be re-written as

Shareholde rs' Equity  Assets - Liabilitie s
• Therefore, the valuation of assets and liabilities
  in the balance sheet determines the book value
  of the shareholders’ equity.


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                     Statement Analysis
               The Balance Sheet –
             Shareholders’ Equity, cont.
• The shareholders’ equity portion of the balance
  sheet is commonly presented in three parts.
    – Capital Stock: the par value of shares issued
    – Additional Paid-In Capital: excess amounts paid in (by
      shareholders) in excess of the par value of the shares
      issued
    – Retained Earnings: the firm’s undistributed earnings




Tom Rourke              FINA 4397 - Financial             16
                         Statement Analysis
    The Balance Sheet - Conclusion
• In summary, the balance sheet views resources
  from two perspectives:
    – As a list of the specific form in which the firm holds
      the resources (i.e., cash, inventory, etc.).
    – As a list of the persons or entities that provided the
      funding to obtain those resources (and thus the
      persons who have a claim on those resources, i.e.
      debt holders and equity holders).
The balance sheet presents the equality of
 investing and financing.

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                         Statement Analysis
             The Income Statement
• The income statement is sometimes titled the
  Statement of Operations, Statement of Earnings,
  or the Statement of Income.
• The income statement presents details on the
  operating profitability of a firm over a particular
  time period (i.e., performance for the year
  ending on March 31, 20XX).
    – It is a “dynamic” statement.



Tom Rourke              FINA 4397 - Financial      18
                         Statement Analysis
       The Income Statement, cont.
• GAAP requires publicly traded firms to use an
  accrual basis of accounting (as opposed to a
  cash    basis)   in    measuring     operating
  performance.
    – Accrual basis accounting records revenues when they
      are earned and expenses when they are incurred
      (regardless of when actual cash flows occur).
    – Cash basis accounting records revenues when cash
      is received and expenses when cash is paid.
• It is this accrual concept that links the balance
  sheet and the income statement.

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                       Statement Analysis
       The Income Statement, cont.
• The bottom line:
 Net Income  Revenues/G ains – Expenses/L osses
• Revenues measure the inflows of net assets
  from selling goods and providing services.
• Expenses measure the outflows of net assets
  that a firm uses in the process of generating
  revenues.
• Gains and losses arise from the sale of assets
  that aren’t directly related to the firm’s business.
Tom Rourke           FINA 4397 - Financial          20
                      Statement Analysis
       The Income Statement, cont.
• The goal of the income statement is to give a
  measure of operating performance that matches
  the firm’s outputs with the firm’s inputs.
• But, keep in mind, because the accrual basis of
  accounting is required
    – revenues reflect sales for cash and sales for credit,
      and
    – expenses reflect purchases made in cash and
      purchases made on credit.
• Therefore, net income includes cash and non-
  cash elements.
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                        Statement Analysis
                  The Statement of
                    Cash Flows
• The statement of cash flows reports for a period
  of time the net cash flows (inflows less outflows)
  from three principal business activities of a firm:
    (1) cash flows from operating activities
    (2) cash flows from investing activities
    (3) cash flows from financing activities
• As this statement reports on the actual cash
  flows for a period, it can be used to disentangle
  the effects of the accrual basis of accounting
  (where non-cash items affect reported net
  income).
Tom Rourke              FINA 4397 - Financial      22
                         Statement Analysis
             The Statement of
             Cash Flows, cont.
• Question: Why is the statement of cash flows so
  important to a financial analyst?
• Answer: Cash flows are vital to a firm’s
  survival.      The statement of cash flows
  integrates the information contained in the
  balance sheet and income statement in a
  manner that allows an analyst to determine what
  the sources and uses of cash were for a firm for
  the specified time period.

Tom Rourke         FINA 4397 - Financial        23
                    Statement Analysis
                  Cash Flows from
                 Operating Activities
 • This section of the statement of cash flows lists
   the sources and uses of cash that arise from the
   normal operations of a firm:
Cash Flow from                                          Changes in
                                  Non-cash   Non-cash
  Operating      = Net Income -            +          - Net Working
                                  Revenues   Expenses
  Activities                                              Capital


 • Operating activities involve the cash effects of
   transactions that enter into the determination of
   net income (i.e., income statement items).

 Tom Rourke                  FINA 4397 - Financial              24
                              Statement Analysis
                  Cash Flows from
                 Investing Activities
• This section of the statement of cash flows lists
  the sources and uses of cash that arise from the
  investing activities of a firm (generally related to
  long-term assets).
• Investing activities include:
    –   buying and selling debt of OTHER firms,
    –   collecting principal payments on debt of other firms,
    –   buying and selling securities of OTHER firms, and
    –   buying and selling property, plant, and equipment.

Tom Rourke                FINA 4397 - Financial                 25
                           Statement Analysis
               Cash Flows from
              Financing Activities
• This section of the statement of cash flows lists
  the sources and uses of cash that arise from the
  financing activities of a firm (generally related to
  long-term liabilities and equity).
• Financing activities include:
    – sales and repurchases of the firm’s equity,
    – dividends to the firm’s stockholders, and
    – issuances and retirements of the firm’s debt.




Tom Rourke              FINA 4397 - Financial         26
                         Statement Analysis
             The Statement of
             Cash Flows, cont.
• The purpose of the statement of cash flows is to
  describe how the firm generated and used cash
  during the reporting period.
• The “bottom line” of the statement of cash flows
  reports the change in the firm’s cash balance
  from the beginning of the reporting period to the
  end of the reporting period.




Tom Rourke          FINA 4397 - Financial        27
                     Statement Analysis
               The Notes to the
             Financial Statements
• The notes to the financial statements generally
  explain the items presented in the main body of
  the statements.
• Examples of notes include:
    – descriptions of the accounting policies used in
      measuring the elements reported in the statements or
    – explanations of uncertainties or contingencies.
• The notes to the financial statements are an
  integral part of the financial statements and
  should be viewed as such.
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                        Statement Analysis
                Common Size
             Financial Statements
• Often, it may be difficult to compare two firms
  because they differ in size (in terms of sales
  levels or total asset levels).
• To resolve this problem, an analyst can create
  “common size” financial statements.
    – A common size balance sheet states all numbers as a
      percentage of total assets.
    – A common size income statement states all numbers
      as a percentage of sales.


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                       Statement Analysis
                   Common Size
             Financial Statements, cont.
• However, interpretation of common size financial
  statements must be made with care.
    – One item in a common size statement is not
      independent of the other items (all items are
      presented as relative values to some base amount).
    – The dollar amount of any one item might increase
      over the period but the item’s relative size can
      decrease at the same time.




Tom Rourke            FINA 4397 - Financial           30
                       Statement Analysis
    Percentage Change Statements
• A percentage change statement will present the
  percentage changes of individual items from the
  previous period to the current period.
• Again, care must be taken in interpreting the
  numbers in a percentage change statement.
  For instance,

%Current Assets  %Cash  %A/R ...


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                    Statement Analysis
       A Final (??) Comment on the
       Financial Statement Package
• It is always important to remember who the
  authors of a financial statement package are
  (the firm’s managers) and what their
  incentives/motivations are (make the firm look
  good).
    – Only    the    actual  financial    statements     and
      accompanying notes are independently viewed by a
      team of auditors!
    – More often than not, quarterly financial information is
      un-audited.


Tom Rourke              FINA 4397 - Financial              32
                         Statement Analysis
 Economic vs. Accounting Earnings
• Keep in mind that the financial statement
  package is only an approximation of reality
  though.
• If the world were certain, we could measure
  economic earnings as
  economic earnings  net cash flow
                      market value of the firm' s net assets
   where the market value of net assets is equal to
   the present value of their future cash flows
   discounted at the risk-free rate.

Tom Rourke               FINA 4397 - Financial                   33
                          Statement Analysis
             Economic vs. Accounting
                 Earnings, cont.
• Unfortunately (or fortunately depending on your
  taste) we live in an uncertain world.
    – We cannot say, with certainty, what will happen
      tomorrow most of the time.
• Therefore, we cannot say, with certainty, what
  an asset’s market price should be.
• In this world of uncertainty, no matter how we
  record earnings, they are only a proxy for
  economic income.


Tom Rourke           FINA 4397 - Financial         34
                      Statement Analysis
             Economic vs. Accounting
                 Earnings, cont.
• Because of this uncertainty, analysts have
  developed different proxies for economic
  earnings.
    – Distributable earnings – the value of dividends that
      could be paid without changing the value of the firm.
    – Sustainable income – the level of income that can
      be maintained given the firm’s stock of capital
      investment.
    – Permanent earnings – the amount that can normally
      be earned given the firm’s assets.

Tom Rourke             FINA 4397 - Financial             35
                        Statement Analysis
             Economic vs. Accounting
                 Earnings, cont.
• But, the accounting framework we’ve begun to
  describe gives us another measure –
  Accounting Earnings.
• The accrual accounting system does not directly
  provide a measure equivalent to those
  previously discussed.
    – It is the analyst’s task to use the accounting
      information to determine the numbers he/she
      wants/needs to value a firm.


Tom Rourke           FINA 4397 - Financial        36
                      Statement Analysis
        Financial Statement Analysis
• Financial statement analysis in general focuses
  on five primary categories:
    –   the firm’s internal liquidity,
    –   the firm’s operating performance,
    –   an analysis of firm risk,
    –   an analysis of growth potential, and
    –   external market liquidity.
• The common approach is to start with ratio
  analysis.
    – We will only highlight a handful of key ratios.
Tom Rourke                FINA 4397 - Financial         37
                           Statement Analysis
         Evaluating Internal Liquidity
• Internal liquidity ratios indicate the ability of the
  firm to meet future short-term financial
  obligations.
• The probability of financial distress decreases
  as the relative liquidity of a firm’s assets
  increases.
    – Liquidity means “nearness to cash,” i.e., cash is the
      most liquid asset a firm can have, a machine might be
      very illiquid if it is difficult to sell to generate cash.
• The focus is on the current portion of the
  balance sheet.
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                          Statement Analysis
       Evaluating Internal Liquidity –
            The Current Ratio
• The current ratio is calculated as:
                              Current Assets
             Current Ratio 
                             Current Liabilitie s
• The analyst must consider how much inventory
  the company carries in assessing this ratio.
• Problem:
    – The effect on the current ratio of an equivalent
      increase in current assets and current liabilities
      depends on whether or not the current ratio was
      previously greater than or less than one.
    – Can be greatly affected by economic conditions.
Tom Rourke              FINA 4397 - Financial         39
                         Statement Analysis
       Evaluating Internal Liquidity –
             The Quick Ratio
• Sometimes, inventories and some other current
  assets may not be very liquid (i.e., easily
  converted into cash).
    – Therefore, they shouldn’t be considered in assessing
      a firm’s ability to meet its current obligations since
      they don’t really add to this ability.
• The quick ratio is calculated as:
                 Cash  Marketable Securities  Receivable s
 Quick Ratio 
                             Current Liabilitie s


Tom Rourke              FINA 4397 - Financial              40
                         Statement Analysis
       Evaluating Internal Liquidity –
             The Cash Ratio
• An even more conservative measure is the cash
  ratio. This ratio assumes that only cash and
  marketable securities should be considered in
  evaluating a firm’s ability to meet its current
  obligations.
• The cash ratio is calculated as:

                            Cash  Marketable Securities
             Cash Ratio 
                                 Current Liabilitie s


Tom Rourke                  FINA 4397 - Financial          41
                             Statement Analysis
     Evaluating Internal Liquidity –
    Accounts Receivables Turnover
• The rate at which A/R turn gives an indication of
  how quickly a firm’s receivables are converted
  into cash.
• The A/R turnover ratio is calculated as:

                       Credit Sales
A/R Turnover 
               Average Account Receivable s



Tom Rourke          FINA 4397 - Financial        42
                     Statement Analysis
     Evaluating Internal Liquidity –
    Accounts Receivables Turnover
• This rate implies an average A/R collection
  period:
                                        365
    Average A/R Collection Period 
                                    A/R Turnover

  i.e., if the Average A/R collection period is 10,
  this implies that on average it takes the firm 10
  days to collect cash from sales on credit.
• Potential problem: Where do we get credit sales
  from?
Tom Rourke           FINA 4397 - Financial         43
                      Statement Analysis
       Evaluating Internal Liquidity –
 Accounts Receivables Turnover, cont.
• Firms might extend credit to induce sales, how
  might this affect receivables turnover?
• Firms make a trade-off in deciding the desirable
  receivables turnover rate.
    – Receivables turnover too high – strict credit policies,
      may be refusing credit to the creditworthy
    – Receivables turnover too low – lax credit policies,
      may be extending too much credit to the non-
      creditworthy.
Large deviations from the industry average A/R
 collection period may be a red flag.
Tom Rourke              FINA 4397 - Financial              44
                         Statement Analysis
       Evaluating Internal Liquidity –
            Inventory Turnover
• The rate at which inventories turn gives an
  indication of how soon they will be sold.
• The inventory turnover ratio is calculated as:

                        Cost of Goods Sold
   Inventory Turnover 
                         Average Inventory




Tom Rourke        FINA 4397 - Financial       45
                   Statement Analysis
       Evaluating Internal Liquidity –
         Inventory Turnover, cont.
• This rate implies             an            average   inventory
  processing time:
                                            365
     Average Inv. Processing Period 
                                      Inv. Turnover
• Question: What would you expect Wal-Mart’s
  average processing time to be? What would you
  expect a jeweler’s average processing time to
  be?
• These ratios vary widely by industry. Be careful
  when comparing across industries.
Tom Rourke            FINA 4397 - Financial                    46
                       Statement Analysis
       Evaluating Internal Liquidity –
         Inventory Turnover, cont.
• Increasing inventory turnover ratios might
  indicate more efficient inventory control systems.
    – A JIT inventory system will increase the inventory
      turnover rate to infinity.
• Firms make a trade-off in deciding the desirable
  inventory turnover rate.
    – Inventory turnover too high – potential inventory
      shortages, may have to turn away customers and
      lose sales
    – Inventory turnover too low – excess inventory on
      hand,     increased   carrying costs,   inventory
      obsolescence

Tom Rourke            FINA 4397 - Financial           47
                       Statement Analysis
       Evaluating Internal Liquidity –
            Inventory Valuation
• These ratios are affected by inventory valuation
  method.
• Three common inventory valuation methods:
    – Average cost – values each unit of inventory at the
      same cost, a weighted average of all inventory units
      EVER purchased.
    – First-In-First-Out (FIFO) – assumes goods are sold in
      order of their purchase by the firm.
    – Last-In-First-Out (LIFO) – assumes goods are sold in
      reverse order of their purchase by the firm.

Tom Rourke             FINA 4397 - Financial             48
                        Statement Analysis
       Evaluating Internal Liquidity –
        Inventory Valuation, cont.
• What we are measuring is cost flow and NOT
  the actual flow of goods.
    – Inventory valuation is a cost allocation mechanism.
• If input prices are
    – Constant:     FIFO = Average = LIFO
    – Rising:       FIFO < Average < LIFO
    – Declining:    FIFO > Average > LIFO
• In making a comparison across firms, if the two
  firms don’t use the same valuation method the
  comparison is NOT reasonable.

Tom Rourke              FINA 4397 - Financial               49
                         Statement Analysis
       Evaluating Internal Liquidity –
        Inventory Valuation, cont.
• FIFO has good balance sheet effects but poor
  income statement effects.
    – On the B/S, inventory is listed closer to replacement
      cost.
    – On the I/S, COGS reflects possibly old input prices.
• LIFO has good income statement effects but
  poor balance sheet effects.
    – On the I/S, COGS reflects more recent input prices.
    – On the B/S, inventory is listed at old replacement
      costs.
Tom Rourke             FINA 4397 - Financial             50
                        Statement Analysis
       Evaluating Internal Liquidity –
           The Operating Cycle
• The operating cycle is the sum of the number of
  days it takes for a firm to sell its inventory and
  convert the resulting receivables into cash.
• We’ve already discussed the components of
  this. The operating cycle can be calculated as

                                               Average Inv.
   Operating        Average A/R
               =                     +          Processing
    Cycle          Collection Period
                                                  Period


Tom Rourke             FINA 4397 - Financial                  51
                        Statement Analysis
       Evaluating Internal Liquidity –
       Accounts Payables Turnover
• The rate at which A/P “turn” gives an indication
  of how quickly a firm pays for purchases on
  account.
• A/P turnover is calculated as:

                        Purchases
  A/P Turnover 
                 Average Account Payables



Tom Rourke         FINA 4397 - Financial        52
                    Statement Analysis
       Evaluating Internal Liquidity –
       Accounts Payables Turnover
• This rate implies an average A/P payment
  period:

                                   365
  Average A/P Payment Period 
                               A/P Turnover

• But how do we calculate purchases?

Purchases COGS  EndingInv. - BeginningInv.


Tom Rourke        FINA 4397 - Financial       53
                   Statement Analysis
       Evaluating Internal Liquidity –
       The Cash Conversion Cycle
• The cash conversion cycle represents, on
  average, the net time interval between the
  collection of cash receipts from product sales
  and the cash payments for the firm’s various
  resource purchases.
• The cash conversion cycle is defined as:

 Cash Conversion        Operating                  Average Payables
                   =                           -
      Cycle              Cycle                      Deferral Period



Tom Rourke             FINA 4397 - Financial                      54
                        Statement Analysis
 Evaluating Operating Performance
• A study of operating performance attempts to
  the assess the managerial ability/competence by
  focusing on operating efficiency and operating
  profitability.
• Operating efficiency refers to how well
  management uses its assets and capital.
• Operating profitability refers to the returns
  management earns by using its assets and
  capital.

Tom Rourke         FINA 4397 - Financial       55
                    Statement Analysis
   Evaluating Operating Efficiency -
        Fixed Asset Turnover
• Fixed asset turnover is defined as:
                                         Net Sales
             Fixed Asset Turnover 
                                    Average Fixed Assets

• Fixed asset turnover indicates the extent to
  which a firm is utilizing existing property, plant,
  and equipment to generate sales.
    – Should be used with caution. Might be better for
      year-to-year comparisons within the same company
      rather than for cross company comparisons.
    – Affected by depreciation methods.
Tom Rourke                  FINA 4397 - Financial          56
                             Statement Analysis
   Evaluating Operating Efficiency -
     Fixed Asset Turnover, cont.
• Potential problems with the use of this ratio:
    – Sales growth is continuous (smooth) while fixed asset
      growth is lumpy, so, a time series of fixed asset
      turnovers may have a strange pattern.
    – The accumulation of depreciation expense increases
      the fixed asset turnover by reducing the average fixed
      assets (in the denominator). Has there really been an
      increase in efficiency as would be implied by an
      increasing ratio?



Tom Rourke              FINA 4397 - Financial             57
                         Statement Analysis
   Evaluating Operating Efficiency -
     Fixed Asset Turnover, cont.
• Possible interpretations:
    – Firms make investments in fixed assets in anticipation
      of higher sales in the future. Thus a low or decreased
      fixed asset turnover may indicate an expanding firm.
    – On the other hand, a firm may cut back on capital
      expenditures if future sales outlooks are not good.
      Thus a high or increasing fixed asset turnover may
      indicate managerial pessimism.




Tom Rourke              FINA 4397 - Financial             58
                         Statement Analysis
   Evaluating Operating Efficiency -
             Depreciation
• Accounting and economic depreciation are two
  different things.
    – Accounting depreciation allocates plant and
      equipment costs over the asset’s useful life.
    – Economic depreciation relates to the real world
      usefulness of an asset.
    – An asset might have little real economic value but still
      be carried on a firm’s books because it is not fully
      depreciated in the accounting sense.



Tom Rourke              FINA 4397 - Financial               59
                         Statement Analysis
   Evaluating Operating Efficiency -
         Depreciation, cont.
• Firms have flexibility                   in   choosing   their
  depreciation method.
    – Most use straight-line for financial reporting purposes.
    – Virtually all (are required to) use accelerated methods
      for tax purposes.
• Straight-line depreciation allocates the cost of a
  depreciable asset evenly over the asset’s
  expected useful life.
• Accelerated methods allocate a larger portion of
  the depreciable asset’s cost in the earlier portion
  of the asset’s expected useful life.
Tom Rourke              FINA 4397 - Financial                 60
                         Statement Analysis
   Evaluating Operating Efficiency -
        Total Asset Turnover
• Total asset turnover is defined as:

                                 Net Sales
     Total Asset Turnover 
                            Average Total Assets
• Total asset turnover indicates the ability to
  manage the level of investment in assets for a
  particular level of sales.
    – In other words, the ability to generate sales from a
      particular investment in assets.


Tom Rourke             FINA 4397 - Financial            61
                        Statement Analysis
 Evaluating Operating Profitability –
        Gross Profit Margin
• The gross profit margin is defined as:
                        Gross Profit Net Sales - Cost of Goods Sold
Gross Profit Margin                
                         Net Sales              Net Sales

• The gross profit margin indicates the basic cost
  structure of the firm.
    – This ratio varies widely by industry. It may not be
      reasonable to compare gross profit margins across
      dissimilar industries.
• Even a small change in the gross profit margin is
  likely to have a major impact on the bottom line.

Tom Rourke                   FINA 4397 - Financial                62
                              Statement Analysis
  Evaluating Operating Profitability –
       Operating Profit Margin
 • The operating profit margin is defined as:
                          Operating Profit Gross Profit - SG & A Expenses
Operating Profit Margin                  
                            Net Sales                Net Sales

 • The variability of the operating profit margin over
   time is an indicator of the business risk for a
   firm.
 • Another option is to replace operating profit by
   earnings before interest, taxes, and depreciation
   (EBITDA).

 Tom Rourke                  FINA 4397 - Financial                    63
                              Statement Analysis
 Evaluating Operating Profitability –
          Net Profit Margin
• The net profit margin is defined as:

                                 Net Income
             Net Profit Margin 
                                  Net Sales
• The net profit margin measures how profitable a
  firm’s sales are after all expenses have been
  deducted.
• Since this factors in interest expense it may be
  more suitable to use for comparing the profit
  performance of different companies than the
  operating profit margin.

Tom Rourke             FINA 4397 - Financial    64
                        Statement Analysis
 Evaluating Operating Profitability –
  Return on Total Capital/Assets
• Return on assets is defined as:

                   Net Income  Interest Expense
             ROA 
                       Average Total Assets

• The return on assets indicates the return from
  operations independent of financing.
• In practice, different analysts may use different
  numbers in the numerator (EAT, EBIT, EBIAT,
  etc.).

Tom Rourke              FINA 4397 - Financial      65
                         Statement Analysis
 Evaluating Operating Profitability –
   Return on Total Capital/Assets, cont.
• The return on             assets              might   have   two
  interpretations:
    – it measures a firm’s ability and efficiency in using its
      assets to generate profits or
    – it reports the total return accruing to all who have
      provided the firm with capital (long- and short-term
      debt holders AND equity holders).




Tom Rourke              FINA 4397 - Financial                   66
                         Statement Analysis
 Evaluating Operating Profitability –
     Return on Owner’s Equity
• Considering all equity (includes preferred stock)
  the return on total equity is defined as:
                                  Net Income
  Return on Total Equity 
                              Average Total Equity
• Considering only common equity the return on
  owner’s equity is defined as:
                     Net Income - Preferred Dividends
             ROE 
                         Average Common Equity

• ROE indicates the return that management has
  earned on the capital provided by the owner.
Tom Rourke                FINA 4397 - Financial         67
                           Statement Analysis
 Evaluating Operating Profitability –
        The Dupont System
• ROE can be disaggregated into various
  components that can provide explanations for
  changes in ROE.
                    Net Income      Net Income      Net Sales
       ROE                                   
               Avg Common Equity     Net Sales Avg Common Equity
               Net Income        Net Sales         Avg Total Assets
                                               
                Net Sales      Avg Total Assets Avg Common Equity

              Profit Margin  Total Asset Turnover  Financial Leverage

• We’ve previously discussed two of these ratios,
  financial leverage will be discussed soon.
Tom Rourke                      FINA 4397 - Financial                      68
                                 Statement Analysis
                   Risk Analysis
• Risk analysis examines the uncertainty of
  income flows for the total firm and for the
  individual sources of capital.
• In this sense, risk comes in two forms, business
  risk and financial risk.
    – Business risk is the uncertainty of income caused by
      the firm’s industry/line of business.
    – Financial risk/leverage is the uncertainty of returns to
      equity holders due to the firm’s use of fixed financing
      obligations.


Tom Rourke              FINA 4397 - Financial               69
                         Statement Analysis
                  Business Risk
• Business risk has two main components, sales
  variability and operating leverage.
    – Sales variability is a prime determinant of earnings
      variability. Sales volatility can be measured by the
      coefficient of variation of sales.
    – Operating leverage refers to the employment of fixed
      production costs. It can be measured as:

                        %profits
                  DOL 
                        %sales
Tom Rourke             FINA 4397 - Financial            70
                        Statement Analysis
              Operating Leverage
• Operating leverage refers to the relative portions
  of fixed versus variable costs in the firm’s total
  cost structure.
• Greater operating leverage (a larger fixed cost
  portion) makes the operating earnings of a firm
  more volatile than sales.
    – During slow periods, operating profits will decline by a
      larger percentage than sales.
    – During expansionary periods, operating profits will
      increase by a larger percentage than sales.


Tom Rourke              FINA 4397 - Financial               71
                         Statement Analysis
                   Financial Leverage
• The employment of fixed financing costs is
  referred to as financial leverage.
• The financial leverage effect relates operating
  income to net income as follows:
                                    operatingincome
                financialleverage 
                                      net income
• Another measure of financial leverage is:
                                        average total assets
              financial leverage 
                                      average common equity
•   Although the two measures look different they reflect on the same issue.

Tom Rourke                     FINA 4397 - Financial                           72
                                Statement Analysis
             Financial Risk Analysis –
             The Debt to Equity Ratio
• The debt to equity ratio is defined as:
                                            Total Debt
               Debt to Equity Ratio 
                                           Total Equity

• As the debt to equity ratio increases, earnings
  per share become more volatile and the
  probability of default increases.
• Recall the M&M propositions which state that (in
  perfect markets) a firm’s WACC is constant.
• Question: Should market values or book values
  be used?
Tom Rourke                FINA 4397 - Financial           73
                           Statement Analysis
       Financial Risk Analysis –
Total Debt Ratio (Debt to Assets Ratio)
• The total debt ratio (debt to assets ratio) is
  defined as:
                                     Total Debt
                 Total Debt Ratio 
                                    Total Assets
• This ratio measures the proportion of the firm’s
  assets that are financed with creditors’ funds.
• Note,
                             Total Debt
              Total Debt
                           Total Assets
             Total Equity                   Total Debt 
                                         1-            
                                          Total Assets 
Tom Rourke                 FINA 4397 - Financial            74
                            Statement Analysis
             Financial Risk Analysis –
                Interest Coverage
• The interest coverage ratio is defined as:
                              EBIT
    Interest Coverage 
                       Interest Expense
                       Net Income  Income Taxes  Interest Expense
                     
                                      Interest Expense

• This ratio indicates how many times the fixed
  interest charges are earned based on the
  earnings available to pay these expenses.
• Obviously, a coverage ratio less than one
  indicates an inability to make necessary interest
  payments.
Tom Rourke                 FINA 4397 - Financial                      75
                            Statement Analysis
              Financial Risk Analysis –
             Cash Flow to Cap Ex Ratio
• The cash flow to capital expenditures ratio is
  defined as:
                                 Cash Flow from Continuing Operations
 Operating Cash Flow /Cap Ex 
                                         Capital Expenditur es

• This provides information about a firm’s ability to
  generate cash flow from operations in excess of
  the capital expenditures needed to maintain and
  build plant capacity.


Tom Rourke                 FINA 4397 - Financial                    76
                            Statement Analysis
        Analysis of Growth Potential
• Investors are concerned about growth potential
  because a firm’s value depends on its ability to
  grow its earnings and dividends.
• Creditors are concerned about growth potential
  because a firm’s future success is a major
  determinant in its ability to pay future obligations.
• Growth depends on two factors, (1) the amount
  of resources retained and reinvested in the
  entity and (2) the rate of return earned on the
  retained resources.


Tom Rourke           FINA 4397 - Financial           77
                      Statement Analysis
 Analysis of Growth Potential, cont.
• The firm’s growth potential is defined as:
             g  retention rate  return on equity
• This is sometimes called the sustainable growth
  rate. It assumes a constant debt to equity ratio.
• The retention rate is defined as:
                                     dividends declared
             retention rate  1-
                                 Operating Income after taxes
• We will use this growth rate later when trying to
  value the equity of firms.

Tom Rourke                   FINA 4397 - Financial              78
                              Statement Analysis
             External Market Liquidity
• Market liquidity is defined as the ability to buy or
  sell an asset quickly with little price change from
  the prior transaction.
    – Liquidity relates to the ease with which one can
      convert an asset into cash or convert cash into an
      asset.
• Hence, shares of Microsoft are highly liquid
  while a stamp collection (or shares of Berkshire
  Hathaway Inc.) may not be.



Tom Rourke            FINA 4397 - Financial           79
                       Statement Analysis
     External Market Liquidity, cont.
• High trading volumes and low bid-ask spreads
  imply liquidity.
    – The bid-ask spread is the difference between the
      price paid to purchase a security and the price
      received for selling a security (bid < ask).
• Another measure of liquidity is trading turnover.
    – Trading turnover is the percentage of shares
      outstanding traded during a period of time.



Tom Rourke           FINA 4397 - Financial          80
                      Statement Analysis
        The Pitfalls of Ratio Analysis
• Ratios provide a convenient way to analyze a
  firm from a financial perspective.
• This approach is not without problems though.
    – A good analyst needs to be wary of some issues that
      can affect the interpretation of a set of financial ratios.




Tom Rourke               FINA 4397 - Financial                 81
                          Statement Analysis
  Financial Statements and Inflation
• Virtually no allowances are made for inflation in
  the actual statements themselves.
    – Some mention of it may be found in the notes or in
      the “Management’s Discussion and Analysis” but the
      numbers reported in the statements have no
      “correction” for inflation.
• The primary areas inflation may affect include
    – interest expense,
    – inventory valuation, and
    – depreciation calculation.

Tom Rourke              FINA 4397 - Financial         82
                         Statement Analysis
             Economic Assumptions
                of Ratio Analysis
• An implicit assumption in (most of) ratio analysis
  is that size is not important.
    We make a proportionality assumption.
• We know that this is assumption is not really
  reasonable though.
    – Economies of scale (or other factors) often exist
      causing a nonlinear relationship between the
      numerator and denominator of a financial ratio.
    – If output doubles, do we expect total costs to double?
      If output then doubles again, do we expect total costs
      to then double again? etc.
Tom Rourke              FINA 4397 - Financial             83
                         Statement Analysis
               Benchmark Issues
               for Ratio Analysis
• A ratio, by itself, doesn’t tell us much. We need
  to compare the ratio to something.
    – Perhaps the same ratio for a competitor, perhaps the
      same ratio for the firm from last year, etc.
    – The comparison must be an appropriate one.
• An appropriate benchmark is determined by the
  needs of the analyst.
    – Lenders may wish to see certain firm traits or
      characteristics that an equity investor might not like.



Tom Rourke              FINA 4397 - Financial              84
                         Statement Analysis
    Timing Issues for Ratio Analysis
• In the U.S., firms are only required to periodically
  report financial information (four times a year).
  It’s worse outside of the U.S.
• The times when financial information is reported
  may not correspond to times of regular
  operations for a firm.
• Or, knowing that analysts use key ratios in
  making      an    investment     recommendation,
  managers may have an incentive to try to
  manipulate the reported figures (to the extent
  that GAAP will allow).
Tom Rourke           FINA 4397 - Financial          85
                      Statement Analysis
             Negative Numbers
             and Ratio Analysis
• Often times a ratio has little (if any) meaning if
  the numerator and denominator have a different
  sign (i.e., a positive numerator and a negative
  denominator or vice versa).
• Or, if both the numerator and denominator are
  negative a ratio may lead the analyst to a false
  conclusion.




Tom Rourke          FINA 4397 - Financial         86
                     Statement Analysis
             Accounting Methods
              and Ratio Analysis
• As the numbers reported in the financial
  statement package are affected by various
  accounting methods employed, any ratios
  computed using those numbers are also
  affected by the various accounting methods
  employed.
The analyst must try to disentangle the effects
  of accounting method choices on financial ratios
  and financial statement analysis in general.

Tom Rourke         FINA 4397 - Financial        87
                    Statement Analysis
       Financial Statement Analysis
       vs. Efficient Capital Markets
• A general description of an efficient market is
  one in which, on average, asset prices
  immediately reflect changes in underlying
  economic variables (i.e., market participants are
  smart/rational).
    – Most (but not all) people/investors believe in some
      degree of market efficiency.
• By nature, the financial statement package
  contains historical information. So …

Tom Rourke            FINA 4397 - Financial            88
                       Statement Analysis
    Financial Statement Analysis
  vs. Efficient Capital Markets, cont.
• Question: If capital markets are believed to be
  efficient, why analyze a set of publicly available
  documents about a firm (that, by their very
  nature, contain “stale” information)?
• Possible answers:
   (1) Someone must perform the analysis in order for the
   market to initially react to the information contained in
   the financial statements.
   (2) Markets might be efficient on average in the
   aggregate but temporarily inefficient at the individual firm
   level.

Tom Rourke               FINA 4397 - Financial               89
                          Statement Analysis
    Financial Statement Analysis
  vs. Efficient Capital Markets, cont.
• Possible answers, cont.
   (3) Financial statements may potentially be biased views
   (even in accordance with GAAP) of a firm’s performance
   if managers have incentives to make them so.
    The Quality of Earnings may actually be poor even
   if the firm reports profits.
   (4) There are other needs for financial statement
   analysis aside from investing in publicly traded common
   stocks (bank lending, credit analysis, etc.)



Tom Rourke             FINA 4397 - Financial             90
                        Statement Analysis

								
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