analysis of fs

8/3/2019 Analysis of Fs

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Objectives of Analysis

6-1

Objectives will vary depending on the

perspective of the financialstatement user

specific questions that areaddressed by the analysis

The identity of the user helps definewhat information is needed.


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Creditors

A creditor is ultimately concerned with the

ability of an existing or prospective

borrower to make interest and principalpayments on borrowed funds.

6-2


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Creditors

What is the borrowing cause?

What is the firms capital structure?

What will be the source of debtrepayment?

6-3

Questions raised in a credit analysisshould include


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Investors

An investor attempts to arrive at an

estimation of a companys future

earnings stream in order to attach a

value to the securities being considered

for purchase or liquidation.

6-4


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Investors

What is the companys performance record? What are the future expectations?

How much risk is inherent in the existing capitalstructure?

What are expected returns?

What is firms competitive position?

6-5

The investment analyst poses questionssuch as:


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Objectives for Analysis

Management

6-6

Management relates to all questionsraised by creditors and investors.

Management must also consider itsemployees, the general public,regulators, and the financial press.


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Management

How well has the firm performed and why?

What operating areas have contributed tosuccess and which have not?

What are strengths and weaknesses of thecompanys financial position?

What changes should be implemented toimprove future performance?

6-7

Looks to financial statement data todetermine


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Financial statements

provide insight into the companys current

status

lead to the development of policies and

strategies for the future

6-8


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Management prepares financial statements.

Analyst should be alert to potential for management to

influence reporting to make data more appealing to

creditors, investors, and other users.It may be helpful to supplement analysis with other

material in the annual report and other sources of

information apart from the annual report.

6-9


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Sources of Information

6-10

Financial statement user has accessto a wide range of data sources.

Objective of analysis dictates theapproach and resources used.

Beginning point should be financial

statements and the notes.


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Sources of Information

6-11

The analyst will want to consider thefollowing resources:

Proxy statement

Auditors report

Management discussion and analysis

Supplementary schedules From 10-K and From 10-Q

Other Sources


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Other Sources of Information

Computerized databases

Enhance analytical process

Provide time-saving features

Computerized financial statement

analysis packages

Perform ratio calculations

Other analytical tools

6-12


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Other Sources of Information

It is important to review the annual reports of

suppliers, customers, and competitors.

Many internet sites charge subscription fees

to access information, but public and

university libraries often subscribe, making

this information free to the public.

6-13


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Tools and Techniques

Common-size financial statements

Key financial ratios

Trend analysis

Structural analysis

Industry comparisons

Common sense and judgment

6-14


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Common-Size Financial Statements

Express each account on the

balance sheet as a percentage of total

assets

income statement as a percentage of net

sales

6-15


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Key Financial Ratios

Five categories of ratios

Liquidity ratios

Activity ratios

Leverage ratios

Profitability ratios

Market ratios

6-16


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Ratios are valuable analytical tools and serve as

screening devices, but they

do not provide answers in and of themselves

are not predictive

should be used with other elements of financial

analysis

6-17


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Liquidity RatiosLiquidity ratios measure a firms ability to meetcash needs as they arise. Liquidity ratiosinclude

current ratio

quick or acid-test ratio

cash flow liquidity ratio

average collection period days inventory held

days payable outstanding

6-18


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Liquidity Ratios

Short-Term Solvency

Measures the ability of a firm to meet debtrequirements as they come due

6-19

Current Ratio

Current assets

Current liabilities


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Liquidity Ratios

Short-Term Solvency

Measures ability to meet short-term cash

needs more rigorously by eliminating

inventory

6-20

Quick or Acid-Test Ratio

Current assets - Inventory

Current liabilities


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Liquidity Ratios

Short-Term Solvency

Focuses on ability of the firm to generate

operating cash flows as a source of liquidity

6-21

Cash Flow Liquidity Ratio

*Cash flow from operating activities

Cash + Marketable securities + CFO *Current liabilities


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Liquidity Ratios

Short-Term Solvency

Helps gauge liquidity of accounts receivable

(ability to collect cash from customers) andmay help provide information about acompanys credit policies

6-22

Average Collection Period

Average accounts receivable * 365

sales per annum


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Liquidity Ratios

Short-Term Solvency

Measures the efficiency of the firm inmanaging its inventory

6-23

Days Inventory Held

Inventory

Average daily cost of sales


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Liquidity Ratios

Short-Term Solvency

Offers insight into a firms pattern ofpayments to suppliers

6-24

Days Payable Outstanding

Accounts payable

Average daily cost of sales


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Cash Conversion Cycle or

Net Trade Cycle

buying or manufacturing inventory, withsome purchases on credit

selling inventory, with some sales on

credit and creation of accounts receivable collecting the cash

6-25

The normal cycle of a firm that consistsof


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Net Trade Cycle

6-26

Helps the analyst understand why cashflow generation has improved or

deteriorated by analyzing key balancesheet accounts that affect cash flow fromoperating activities:

Accounts Receivable Inventory Accounts Payable


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Net Trade Cycle

Average collection period

plusDays inventory held

minus

Days payable outstandingequals

Cash conversion or net trade cycle

6-27

Calculated as follows


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Activity Ratios

Activity ratios measure the liquidity of specific

assets and the efficiency of managing assets.

Activity ratios include accounts receivable turnover

inventory turnover

accounts payable turnover fixed asset turnover

total asset turnover

6-28


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Activity Ratios: Asset Liquidity,

Asset Management Efficiency

Measures efficiency of firms collection andcredit policies

6-29

Accounts Receivable Turnover

Net sales

Net accounts receivable


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Measures firms efficiency in managing its

inventory

6-30

Inventory Turnover

Cost of goods sold

Inventory


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Helps to gain insight into a firms pattern ofpayment to suppliers

6-31

Accounts Payables Turnover

Cost of goods sold

Accounts payable


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Assesses effectiveness in generating sales frominvestments in fixed assets

6-32

Fixed Asset Turnover

Net sales

Net property, plant, equipment


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Assesses effectiveness in generating sales

from investments in all assets

6-33

Total Asset Turnover

Net sales

Total assets


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Leverage RatiosLeverage ratios measure the extent of a firms

financing with debt relative to equity and its

ability to cover interest and other fixed

charges.

6-34


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Leverage RatiosLeverage ratios include

Debt ratio

Long-term debt to total capitalization

Debt to equity

Times interest earned

Fixed charge coverage

Cash flow adequacy

6-35


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Leverage Ratios

Debt Financing and Coverage

Considers the proportion of all assets that

are financed with debt

6-36

Debt Ratio

Total liabilities

Total assets


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Leverage Ratios


Reveals the extent to which long-term debt

is used for the firms permanent financing(both long-term debt and equity)

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Long-term Debt to Total Capitalization

Longterm debt

Long-term debt + Stockholders equity


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Leverage Ratios:

Debt Financing and Coverage (cont.)

Measures the riskiness of the firms capital

structure in terms of the relationshipbetween the funds supplied by creditors(debt) and investors (equity)

6-38

Debt to Equity

Total liabilities

Stockholders equity


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Leverage Ratios


Indicates how well operating earnings cover

fixed interest expenses

6-39

Times Interest Earned

Operating profit

Interest expense


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Leverage Ratios


Measures how many times interest

payments can be covered by cash flow fromoperations before interest and taxes

6-40

Cash Interest Coverage

CFO + interest paid + taxes paid

Interest paid


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Leverage Ratios


Broader measure of how well operating

earnings cover fixed charges

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Fixed Charge Coverage

*Rent expense = operating lease payments

Operating profit + Rent expense

Interest expense + Rent expense


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Leverage Ratios


Measures firms ability to cover capital

expenditures, long-term debt payments anddividends each year

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Cash Flow Adequacy

Cash flow from operating activitiesCapital expenditures + debt repayments

+ dividends paid


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Profitability ratios measure the overall

performance of a firm and its efficiency in

managing assets, liabilities, and equity.

6-43


Profitability Ratios


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Profitability ratios include

gross profit margin

operating profit margin

net profit margin cash flow margin

return on total assets (ROA) or return on investment

(ROI)

return on equity (ROE) cash return on assets

6-44




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Overall Efficiency and Performance

Measures ability of a company to control

costs of inventories or manufacturing of

products and to pass along price increases

through sales to customers

6-45

Gross Profit Margin

Gross profit

Net sales


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Measures overall operating efficiency and

incorporates all of the expenses associated

with ordinary business activities

6-46

Operating Profit Margin

Operating profit

Net sales


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Measures profitability after consideration

of all revenue and expense, including

interest, taxes, and nonoperating items

6-47

Net Profit Margin

Net earnings

Net sales


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Measures ability to translate sales into cash

6-48

Cash Flow Margin

Cash flow from operating activitiesNet sales


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Measures overall efficiency of firm inmanaging investment in assets andgenerating profits

6-49

Return on Total Assets (ROA) or Returnon Investment (ROI)

Net earnings

Total assets


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Measures rate of return on stockholdersinvestment

6-50

Return on Equity (ROE)

Net earnings

Stockholders equity


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Measures firms ability to generate cash

from the utilization of its assets

6-51

Cash Return on Assets

Cash flow from operating activitiesTotal assets

K Fi i l R i


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Market Ratios

6-52

Market ratios measure returns tostockholders and the value the

marketplace puts on a companys stock.Market ratios include

earnings per common share

price-to-earnings dividend payout dividend yield


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Market Ratios

Earnings per Common Share

Provides the investor with a common

denominator to gauge investment returns

6-53

Earnings per Common Share

Net earnings

Average shares outstanding


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Market Ratios

Price-to-Earnings

Relates earnings per common share to the

market price at which the stock trades,expressing the multiple that the stockmarket places on a firms earnings

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Price-to-Earnings

Market price of common stock

Earnings per share


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Market Ratios

Dividend Payout

Determined by the formula cash dividends

per share divided by earnings per share

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Dividend Payout

Dividends per share

Earnings per share

Market Ratios


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Market Ratios

Dividend Yield

Shows the relationship between cash

dividends and market price

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Dividend Yield

Dividends per share

Market price of common stock


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Analyzing the Data

There are five broad areas that would typically

constitute a fundamental analysis of financial

statements:

Background on the firm, industry, economy, and

outlook

Short-term liquidity

Operating efficiency Capital structure and long-term solvency

Profitability

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Background: Economy Industry


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Background: Economy, Industry,

and Firm

Economic developments and the actions of

competitors affect the ability of any business

enterprise to perform successfully.It is necessary to evaluate the environment in

which the firm conducts business.

This process involves blending hard facts with

guess and estimates.

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Short-Term Liquidity

Especially important to creditors, suppliers,

management, and others who are concerned

with the ability of a firm to meet near-term

demands for cash

Should include analysis of selected financial ratios

and a comparison with industry averages

Predicts the future ability of the firm to meetprospective needs for cash

6-59


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Operating Efficiency

Turnover ratios measure the operating

efficiency of a firm.

The efficiency in managing a companys

accounts receivable, inventory, and

accounts payable is discussed in the short-

term liquidity analysis.

6-60

Capital Structure and


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Capital Structure and

Long-Term Solvency

Analytical process includes an evaluation

of the amount and proportion of debt

in a firms capital structure as well asthe ability to service debt.

Debt financing implies risk and leverage.

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Profitability

Analysis of how well the firm has

performed in terms of profitability,

beginning with the evaluation of severalkey ratios

6-62

Relating the Ratios


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Relating the Ratios

The Du Pont System

Helpful to complete the evaluation of a firm byconsidering the interrelationship among theindividual ratios

Looks at how the various pieces of financialmeasurement work together to produce anoverall return

Helps analyst see how the firms decisions and

activities over the course of an accountingperiod interact to produce overall return toshareholders

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Relating the Ratios


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Relating the Ratios

The Du Pont System

6-64

The summary ratios used are the following:

(1)Net profit margin

(2)Total asset turnover

(3)Return on investment

(3)

Return on investment

(4)

Financial leverage

(5)

Return on equity

Net income Net sales Net income

Net sales X Total assets = Total assets

Net income Total assets Net income

Total assets X Stockholder equity = Stockholder equity

Relating the Ratios


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Relating the Ratios

The Du Pont System

The first three ratios reveal that return oninvestment is a product of the net profit

margin and the total asset turnover.The second three ratios show how the

return on equity is the product of returnon investment and financial leverage.

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Relating the Ratios


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Relating the Ratios

The Du Pont System

By reviewing this series of relationships, theanalyst can identify strengths and weaknessesas well as trace potential causes of problems in

the overall financial condition and performanceof the firm.

Analyst can evaluate changes in condition andperformance.

Evaluation can then focus on specific areascontributing to changes.

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Projections and


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Projections and

Pro Forma Statements

Pro forma financial statements areprojections based on a set of assumptions

regarding future revenues

expenses

level of investment in assets

financing methods and costs

working capital management

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Projections and


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Projections and

Pro Forma Statements

Pro forma financial statements are usedprimarily for long-range planning and

long-term credit decisions.Many firms have made up their own

definitions of pro forma statements,which should not be confused with the

pro forma statement described above.

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Summary of Analysis

Analysis of any firms financial statements consists

of a mixture of steps and pieces that interrelate

and affect each other.No one part of the analysis should be interpreted

in isolation.

The last step of analysis is to integrate the separate

pieces into a whole, leading to conclusions

about the business enterprise.

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