1 chapter eight financial statement analysis mcgraw-hill/irwin © 2006 the mcgraw-hill companies,...
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Chapter Eight
Financial Statement Analysis
McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
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The Major Financial StatementsThe Major Financial Statements
Income Statement Income Statement Balance Sheet Balance Sheet Statement of Cash FlowsStatement of Cash Flows
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Income StatementIncome Statement
Device for measuring profitability of a firmDevice for measuring profitability of a firm Defined period of timeDefined period of time
• One monthOne month• Three monthsThree months• One yearOne year• Etc.Etc.
Continued Continued
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Income StatementIncome Statement
Presented in stair-Presented in stair-
step fashionstep fashion
Shows profit after eachtype of expense itemis deducted from revenues
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Balance SheetBalance Sheet
LiabilitiesLiabilities Assets = +Assets = + Owner’s EquityOwner’s Equity
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Balance SheetBalance Sheet
What the firm ownsWhat the firm owns
How assets are financed withHow assets are financed with
The firmsThe firms
ContinuedContinued
LiabilitiesLiabilities ororOwnership Ownership InterestInterest HoldingsHoldings
andandObligationsObligations
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Balance SheetBalance Sheet
It is datedIt is dated
Does NOT represent result of transactions Does NOT represent result of transactions for a specific month, quarter, or yearfor a specific month, quarter, or year
Cumulative chronicle of all transactions Cumulative chronicle of all transactions affecting the corporation since its inceptionaffecting the corporation since its inception
Generally, based on original cost basis Generally, based on original cost basis NOT current market valueNOT current market value
End of calendar year, orEnd of calendar year, orEnd of fiscal yearEnd of fiscal year
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Income Statement & Balance SheetIncome Statement & Balance SheetANSWER TWO QUESTIONSANSWER TWO QUESTIONS
IncomeIncomestatementstatement
How much did the How much did the
firm make or losefirm make or lose
Balance Balance SheetSheet
How much is How much is the firm worththe firm worth
ShowsShows
ShowsShows
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Statement of Cash FlowsStatement of Cash Flows
Referred to in theReferred to in the
Statement of Financial Accounting (SFAS)Statement of Financial Accounting (SFAS) No. 95No. 95 Replaced the Replaced the
Old statement of changes in financial positionOld statement of changes in financial position
(and the source and uses of funds statement)(and the source and uses of funds statement)
ContinuedContinued
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Statement of Cash FlowsStatement of Cash Flows
Shows the critical nature of cash flowShows the critical nature of cash flow to the operations of the firmto the operations of the firm RepresentsRepresents
• Cash, orCash, or• Cash-equivalent, e.g. money market fundCash-equivalent, e.g. money market fund
ContinuedContinued
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Statement of Cash FlowsStatement of Cash Flows
Three primary sections:Three primary sections:
1. Cash flows from operating activities1. Cash flows from operating activities
2. Cash flow from investing activities2. Cash flow from investing activities
3. Cash flow from financing activities3. Cash flow from financing activities
Above results added Above results added together compute net together compute net increaseincrease or or decreasedecrease in cash flowin cash flow
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Key Financial Ratios for the Key Financial Ratios for the Security AnalystSecurity Analyst
Ratio AnalysisRatio Analysis Bankruptcy StudiesBankruptcy Studies Classification SystemClassification System
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Ratio AnalysisRatio Analysis
Financial ratiosFinancial ratios
of a firmof a firm
Weigh &
Evaluate
Operating Operating performanceperformance
CapitalCapitalstructurestructure
Continued
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Ratio AnalysisRatio Analysis
Compare firm’sCompare firm’s
ratio results withratio results with
Similar firms inSimilar firms in the industrythe industry
Own firm’s past Own firm’s past performanceperformance
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Who might be, in particular, Who might be, in particular, interested in the ratios?interested in the ratios?
All StakeholdersAll Stakeholders
Present and ProspectivePresent and Prospective
ANSWER:
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Who might be, in particular, Who might be, in particular, interested in the ratios?interested in the ratios?
Investors Investors ManagersManagers LendersLenders CustomersCustomers EmployeesEmployees CompetitorsCompetitors IRS (perhaps?)IRS (perhaps?)
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Bankruptcy StudiesBankruptcy Studies
picking picking
continual loserscontinual losers
Ratio analysisRatio analysis
ProtectsProtects
picking picking winnerswinners
an in
vesto
r fro
m
an in
vesto
r fro
m
NOT NOT guaranteeingguaranteeing
Bankruptcy StudiesBankruptcy StudiesThe Z (zeta) ScoreThe Z (zeta) Score
Variables or ratiosVariables or ratios What they can What they can indicateindicate
11Cumulative Cumulative ProfitabilityProfitability
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Earnings stability Earnings stability during the last 10 during the last 10 yearsyears
assets Totalearnings Retained
assets Total
income operating ofdeviation Standard
Continued
Bankruptcy StudiesBankruptcy StudiesThe Z (zeta) ScoreThe Z (zeta) Score
Variables or ratiosVariables or ratios What they can What they can indicateindicate
33Productivity of Productivity of
operating assetsoperating assets
44Leverage ratio,Leverage ratio,
interest coverageinterest coverage
55 Liquidity ratioLiquidity ratio
Interest
taxesandinterest before Earning
Cont.Cont.
assets Total
taxesandinterest before Earning
sliabilitieCurrent
assetsCurrent
Continued
2020
Bankruptcy StudiesBankruptcy StudiesThe Z (zeta) ScoreThe Z (zeta) Score Cont.Cont.
Variables or ratiosVariables or ratios What they can What they can indicateindicate
66 Leverage ratioLeverage ratio
77 Total assetsTotal assets Proxy for the Proxy for the size of the firmsize of the firm
equity of Book value
stockcommon of ueMarket val
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Classification System20 Significant Ratios Divided Into
6 Primary Groupings(Groups A through F)
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Classification System Classification System Group A – Profitability RatiosGroup A – Profitability Ratios
11 Gross profit marginGross profit margin
22 After-tax profit marginAfter-tax profit margin
33 Return on assetsReturn on assets
44 Return on equity (ROE)Return on equity (ROE)
(revenue) Sales
profit Gross
assets Total
incomeNet
Sales
incomeNet
equity rs'Stockholde
incomeNet
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Return on Equity (ROE) Return on Equity (ROE) Dupont AnalysisDupont Analysis
If ROE is unsatisfactory, the Du Pont If ROE is unsatisfactory, the Du Pont Analysis helps locate which part of the Analysis helps locate which part of the business is underperformingbusiness is underperforming
Shows the relationship between income statement & balance sheet
Age of assets must be considered
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Return on Equity (ROE) Return on Equity (ROE) Dupont AnalysisDupont Analysis
Breaks down (ROE) into three parts:Breaks down (ROE) into three parts:
RATIORATIO INDICATES/INDICATES/MEASURESMEASURES
Profit marginProfit margin Operating efficiencyOperating efficiency
Total asset turnoverTotal asset turnover Asset use efficiencyAsset use efficiency
Financial leverageFinancial leverage Measured by the equity Measured by the equity multipliermultiplier
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Classification System Classification System Group B – Asset-utilization ratiosGroup B – Asset-utilization ratios
55 Receivables turnoverReceivables turnover
66 Inventory turnoverInventory turnover
77 Fixed-asset turnoverFixed-asset turnover
88 Total Asset turnoverTotal Asset turnover
sReceivable
Sales
Inventory
Sales
assets Total
Sales
assets Fixed
Sales
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Classification System Classification System Group C – Liquidity RatiosGroup C – Liquidity Ratios
99 Current ratioCurrent ratio
1010 Quick ratioQuick ratio
1111Net working capital to Net working capital to total assetstotal assets
sliabilitieCurrent
assetsCurrent
sliabilitieCurrent
Inventory - assetsCurrent
assets Total
sliabilitieCurrent - assetsCurrent
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Classification System Classification System Group D – Debt-utilization RatiosGroup D – Debt-utilization Ratios
1212 Long-term debt to equityLong-term debt to equity
1313Total debt to total assetsTotal debt to total assets
1414Times interest earnedTimes interest earned
1515Fixed charge coverageFixed charge coverage
equity rs'Stockholde
debt term-Long
assets Total
debt Total
Interest
taxes&interest before Income
Interest
taxes& charges fixed before Income
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Classification System Classification System Group E – Price RatiosGroup E – Price Ratios
1616Price to earnings Price to earnings
(P/E ratio)(P/E ratio)
1717 Price to book valuePrice to book value
1818Dividend to price Dividend to price
(dividend yield)(dividend yield)
shareper Earnings
pricestock Common
shareper Book value
pricestock Common
pricestock Common
shareper Dividends
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Classification System Classification System Group F – Other RatiosGroup F – Other Ratios
1919 Average tax rateAverage tax rate
2020 Dividend payoutDividend payout
income Taxable
taxIncome
shareper Earnings
shareper Dividends
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Uses of RatiosUses of Ratios
Check the health of companies Check the health of companies Compare and analyze the 20 ratiosCompare and analyze the 20 ratios NOTE: Past growth rates are not a good NOTE: Past growth rates are not a good
prediction of future growth ratesprediction of future growth rates P/E ratio an indication ofP/E ratio an indication of
• Financial risk Financial risk • GrowthGrowth• ProfitabilityProfitability
Continued
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Uses of RatiosUses of Ratios
One-year data doesn’t give direction of One-year data doesn’t give direction of company’s future performancecompany’s future performance
Long-term trend analysis focuses onLong-term trend analysis focuses on• Increasing/decreasing performanceIncreasing/decreasing performance
• Volatility (riskiness) of the resultsVolatility (riskiness) of the results
Cont.
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Comparing Long-Term TrendsComparing Long-Term Trends
Business cycleBusiness cycle Trend analysisTrend analysis Long term performanceLong term performance Growth rates (over 5 and 10 years)Growth rates (over 5 and 10 years) Stable vs. volatile earningsStable vs. volatile earnings The stronger the financial condition the The stronger the financial condition the
lower the risklower the risk
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Deficiencies of Financial StatementsDeficiencies of Financial Statements
Inflation EffectsInflation Effects Inventory Valuation Inventory Valuation Extraordinary Gains and LossesExtraordinary Gains and Losses Pension Fund Liabilities Pension Fund Liabilities Foreign Exchange Transactions Foreign Exchange Transactions Other DistortionsOther Distortions
Six areas that a financial analyst Six areas that a financial analyst should questionshould question
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Inflation EffectsInflation Effects
Inflation has been mild in the last decadeInflation has been mild in the last decade Must be aware of potential effects of Must be aware of potential effects of
inflation for the futureinflation for the future Inflation causesInflation causes
• Phantom profitPhantom profit
• Profit may be as a result of increase in Profit may be as a result of increase in prices (inflation) NOT satisfactory prices (inflation) NOT satisfactory performanceperformance
Continued
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Inflation EffectsInflation Effects
Industries most sensitive to inflation-induced Industries most sensitive to inflation-induced profits:profits:• Lumber Lumber (50% of profits due to inventory pricing)(50% of profits due to inventory pricing)
• CopperCopper
• RubberRubber
• Food productsFood products
Cont.
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Inventory Valuation Inventory Valuation
Inventory valuation methods Inventory valuation methods • LIFO (last-in, first-out)LIFO (last-in, first-out)
• FIFO (first-in, first-out)FIFO (first-in, first-out) In inflationary economy, profit increases In inflationary economy, profit increases
without increase in output without increase in output Inventory turnover appears higher in Inventory turnover appears higher in
LIFO than FIFOLIFO than FIFO
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Extraordinary Gains and LossesExtraordinary Gains and Losses
Sale of corporate assetsSale of corporate assets LawsuitsLawsuits Inflate/deflate returns Inflate/deflate returns Forecasting should include earnings Forecasting should include earnings
ONLY from continuing operationsONLY from continuing operations Big impact on ratiosBig impact on ratios
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Pension Fund Liabilities Pension Fund Liabilities
Increasing concern among financial analystsIncreasing concern among financial analysts Undefined liabilities of pension fundsUndefined liabilities of pension funds Current obligations may have to come out Current obligations may have to come out
from future earningsfrom future earnings
Penalize shareholdersPenalize shareholders
Limit ability to reinvest in new assetsLimit ability to reinvest in new assets
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Foreign Exchange Transactions Foreign Exchange Transactions
Foreign currency fluctuations impact Foreign currency fluctuations impact earnings of companies doing earnings of companies doing international tradeinternational trade
If US $ earnings from foreign If US $ earnings from foreign subsidiaries translate to more US $ subsidiaries translate to more US $
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Other DistortionsOther Distortions
Detective work needed in accounting Detective work needed in accounting methods (e.g. Enron)methods (e.g. Enron)
R&D expendituresR&D expenditures Deferred taxesDeferred taxes Tax creditsTax credits Merger accountingMerger accounting Intangible drillingIntangible drilling Development costsDevelopment costs Percentage depletion allowancesPercentage depletion allowances
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WEBSITEWEBSITE COMMENTSCOMMENTS
www.zacks.comwww.zacks.com Provides detailed company Provides detailed company financial information and financial information and ratios—mostly free. ratios—mostly free.
www.investor.reuters.comwww.investor.reuters.com Provides detailed financial Provides detailed financial information, including ratios information, including ratios and statements. and statements.
www.morningstar.comwww.morningstar.com
Provides financial Provides financial information and ratios for information and ratios for free, some information fee free, some information fee based. based.
www.investors.comwww.investors.com Provides investment Provides investment related charts and tools.related charts and tools.
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WEBSITEWEBSITE COMMENTSCOMMENTS
www.valueline.comwww.valueline.com Is a web version of print Is a web version of print information source.information source.
www.investopedia.comwww.investopedia.com Provides tutorials on Provides tutorials on financial ratios.financial ratios.
www.ventureline.comwww.ventureline.com
Allows access to financial Allows access to financial ratios and other analytics, ratios and other analytics, requires registration for requires registration for access, and is fee based. access, and is fee based.
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SummarySummary
Basic accounting statementsBasic accounting statements• Income statementIncome statement• Balance sheetBalance sheet• Statement of cash flowsStatement of cash flows
Ratio analysisRatio analysis Ratios can not help to find a gold mine Ratios can not help to find a gold mine
but can help avoid sick companiesbut can help avoid sick companies 20 ratios in 6 categories20 ratios in 6 categories