(c) 2007 prentice hall, inc.5-1 the analysis of financial statements ratios are tools and their...

(C) 2007 Prentice Hall, Inc.(C) 2007 Prentice Hall, Inc.

5-5-11

The Analysis of The Analysis of Financial StatementsFinancial StatementsRatios are tools and their value is limited when used alone. The more tools used, the better the analysis. For example, you can’t use the same golf club for every shot and expect to be a good golfer. The more you practice with each club, however, the better able you will be to gauge which club to use on one shot. So to, we need to be skilled with the financial tools we use. - Diane Morrison

- CEO, R.E.C. Inc.


5-5-22

Objectives of AnalysisObjectives of Analysis

Remember--the identity of the user helps Remember--the identity of the user helps define what information is needed define what information is needed

Objectives will vary depending on the Objectives will vary depending on the perspective of theperspective of the financial statement userspecific questions that are addressed

by the analysis


5-5-33

CreditorsCreditors

A creditor is ultimately concerned A creditor is ultimately concerned with the ability of an existing or with the ability of an existing or prospective borrower to make prospective borrower to make interest and principal payments interest and principal payments on borrowed funds on borrowed funds


5-5-44

CreditorsCreditors (cont.)(cont.)

What is the borrowing cause?What is the borrowing cause? What is the firm’s capital What is the firm’s capital

structure?structure? What will be the source of debt What will be the source of debt

repayment? repayment?

Questions raised in a credit analysis should include:


5-5-55

InvestorsInvestors

An investor attempts to arrive at an An investor attempts to arrive at an estimation of a company’s future estimation of a company’s future earnings stream in order to earnings stream in order to attach a value to the securities attach a value to the securities being considered for purchase or being considered for purchase or liquidation liquidation


5-5-66

InvestorsInvestors (cont.)(cont.)

How has the firm performed/what How has the firm performed/what are future expectations?are future expectations?

How much risk is inherent in the How much risk is inherent in the existing capital structure?existing capital structure?

What are expected returns?What are expected returns? What is firm’s competitive What is firm’s competitive

position?position?

The investment analyst poses questions as:


5-5-77

ManagementManagement

How well the firm has performed and why?How well the firm has performed and why? What operating areas have contributed to What operating areas have contributed to

success and which have not?success and which have not? What are strengths/weaknesses of What are strengths/weaknesses of

company’s financial position?company’s financial position? What changes should be implemented to What changes should be implemented to

improve future performance?improve future performance?

Looks to financial statement data to determine:


5-5-88

Caution!!!Caution!!! Keep in mind: Management Keep in mind: Management

PREPARES financial statementsPREPARES financial statements Analyst should be alert to potential for Analyst should be alert to potential for

management to influence reporting to management to influence reporting to make data more “appealing”make data more “appealing”

May want to supplement analysis with May want to supplement analysis with other sources of information apart other sources of information apart from the Annual Report prepared by from the Annual Report prepared by managementmanagement


5-5-99

Sources of InformationSources of Information

Proxy StatementProxy Statement

Auditor’s ReportAuditor’s Report

MD&AMD&A

Supplementary schedulesSupplementary schedules

Form 10-K and Form 10-QForm 10-K and Form 10-Q

The analyst will want to consider the following resources:


5-5-1010

Other Sources of Other Sources of InformationInformation Computerized data basesComputerized data bases

Info on industry norms/ratiosInfo on industry norms/ratios Info on particular Info on particular

companies/industriescompanies/industries

Ever-expanding financial and Ever-expanding financial and investment websites investment websites

Articles in popular/business press Articles in popular/business press


5-5-1111

Tools and TechniquesTools and Techniques

Common-size financial statementsCommon-size financial statements

Financial ratiosFinancial ratios

Trend analysisTrend analysis

Structural analysisStructural analysis

Industry comparisonsIndustry comparisons

These include:These include:

Most important:Most important:Common sense and judgment


5-5-1212

Common-Size Common-Size Financial StatementsFinancial Statements

Express each account on the Express each account on the balance sheetbalance sheet as a percentage as a percentage

of total assets of total assets income statementincome statement as a as a

percentage of net sales percentage of net sales


5-5-1313

Key Financial RatiosKey Financial Ratios

Standardize financial data in terms Standardize financial data in terms of mathematical relationships of mathematical relationships expressed in the form of expressed in the form of

PercentagesPercentages

TimesTimes

DaysDays


5-5-1414

Key Financial RatiosKey Financial Ratios (cont.)(cont.)

Liquidity (Short-term liquidity)Liquidity (Short-term liquidity) ActivityActivity Leverage (Long-term solvency) Leverage (Long-term solvency) ProfitabilityProfitability MarketMarket


5-5-1515

Key Financial RatiosKey Financial Ratios (cont.)(cont.)

1.1. Liquidity RatiosLiquidity Ratios

Measure a firm’s ability to meet Measure a firm’s ability to meet cash needs as they arise cash needs as they arise

Five Categories of key financial ratios:


5-5-1616

Key Financial RatiosKey Financial Ratios

(cont.)(cont.)

2.2. Activity RatiosActivity Ratios

Measure the liquidity of specific Measure the liquidity of specific assets and the efficiency of assets and the efficiency of managing assetsmanaging assets



5-5-1717

Key Financial RatiosKey Financial Ratios (cont.) (cont.)

3.3. Leverage Ratios (Long-term Leverage Ratios (Long-term solvency)solvency)

Measure the extent of a firm’s Measure the extent of a firm’s financing with debt relative to financing with debt relative to equity and its ability to cover equity and its ability to cover interest and other fixed charges interest and other fixed charges



5-5-1818

4.4. Profitability RatiosProfitability Ratios

Measure the overall performance of Measure the overall performance of a firm and its efficiency in a firm and its efficiency in managing assets, liabilities and managing assets, liabilities and equity equity

Key Financial Ratios (cont.)



5-5-1919

Cautions!Cautions!

Ratios are valuable analytical tools Ratios are valuable analytical tools and serve as screening devices, and serve as screening devices, BUT. . .BUT. . .

They do not provide answers in and of They do not provide answers in and of themselves themselves

They are not predictiveThey are not predictive Ratios should be used with other elements of Ratios should be used with other elements of

financial analysisfinancial analysis There are no “rules of thumb” that apply to There are no “rules of thumb” that apply to

the interpretation of ratiosthe interpretation of ratios


5-5-2020

Liquidity Ratios: Liquidity Ratios: Short-Term SolvencyShort-Term Solvency

Measures ability to meet short-Measures ability to meet short-term cash needs term cash needs

Current RatioCurrent Ratio

Current assetsCurrent assets

Current liabilitiesCurrent liabilities


5-5-2121

Liquidity Ratios: Liquidity Ratios: Short-Term SolvencyShort-Term Solvency (cont.) (cont.)

Measures ability to meet short-term cash needs Measures ability to meet short-term cash needs

more rigorously by eliminating inventorymore rigorously by eliminating inventory

Quick or Acid-Test Ratio

Current assets - InventoryCurrent assets - Inventory


(Cash+short-term investments + A/R)

current liabilities


5-5-2222

Liquidity Ratios: Liquidity Ratios: Short-Term SolvencyShort-Term Solvency (cont.) (cont.)

Focuses on ability of the firm to Focuses on ability of the firm to generate operating cash flows generate operating cash flows as a source of liquidityas a source of liquidity

Cash Flow Liquidity Ratio

*Cash flow from operating

activities

Cash + Marketable securities + Cash + Marketable securities + CFO *CFO *



5-5-2323

Liquidity RatiosLiquidity Ratios

Short term liquidity 2006 2005 2004 2003Current Ratio 1,18 1,43 2,04 1,65 Quick Ratio 0,52 0,68 0,86 0,40 Cash Flow Liquidity 0,55 1,21 1,61 0,92

A. Cam


5-5-2424

Activity Ratios: Asset Activity Ratios: Asset Liquidity, Asset Liquidity, Asset Management EfficiencyManagement Efficiency

Another measure of efficiency of firm’s Another measure of efficiency of firm’s collection and credit policiescollection and credit policies

Accounts Receivable TurnoverAccounts Receivable Turnover

net s,receivable tradeAverage

net sales,Credit

turnoverreceivable

365


5-5-2525

Activity Ratios: Asset Activity Ratios: Asset Liquidity, Asset Management Liquidity, Asset Management EfficiencyEfficiency (cont.)(cont.)

Another measure of firm’s efficiency Another measure of firm’s efficiency in managing its inventoryin managing its inventory

Inventory Turnover

sinventorie average

sold goods ofCost

turnoverinventory

365


5-5-2626

Activity Ratios: Asset Activity Ratios: Asset Liquidity, Asset Management Liquidity, Asset Management EfficiencyEfficiency (cont.) (cont.)

Another way to gain insight into a firm’s Another way to gain insight into a firm’s pattern of payment to supplierspattern of payment to suppliers

Payables Turnover

payables tradeAverage

sinventoriein COGS

turnoverpayable

365


5-5-2727

Cash Conversion Cycle or Cash Conversion Cycle or Net Trade CycleNet Trade Cycle

Buying or manufacturing Buying or manufacturing inventory, with some purchases inventory, with some purchases on crediton credit

Selling inventory, with some sales Selling inventory, with some sales on crediton credit

Collecting the cash Collecting the cash

The normal cycle of a firm that The normal cycle of a firm that consists of:consists of:


5-5-2828

Cash Conversion Cycle or Cash Conversion Cycle or Net Trade CycleNet Trade Cycle (cont.)(cont.)

Key balance sheet accounts that affect Key balance sheet accounts that affect cash flow from operating activitiescash flow from operating activities

Accounts ReceivableAccounts Receivable InventoryInventory Accounts PayableAccounts Payable

Helps the analyst understand why Helps the analyst understand why cash cash flow generation has flow generation has improved or improved or deteriorated by deteriorated by analyzing:analyzing:


5-5-2929

Cash Conversion Cycle or Cash Conversion Cycle or Net Trade CycleNet Trade Cycle (cont.)(cont.)

Average collection periodAverage collection periodPlusPlus

Days inventory heldDays inventory heldMinusMinus

Days payable outstandingDays payable outstandingEqualsEquals

Cash conversion or net trade cycleCash conversion or net trade cycle

Calculated as follows:Calculated as follows:


5-5-3030

Activity Ratios: Asset Activity Ratios: Asset Liquidity, Asset Management Liquidity, Asset Management EfficiencyEfficiency (cont.)(cont.)

Assesses effectiveness in generating Assesses effectiveness in generating sales from investments in fixed sales from investments in fixed assetsassets

Fixed Asset Turnover

Net salesNet sales

Net property, plant, equipmentNet property, plant, equipment(Average)(Average)


5-5-3131

Activity Ratios: Asset Activity Ratios: Asset Liquidity, Asset Management Liquidity, Asset Management EfficiencyEfficiency (cont.) (cont.)

Assesses effectiveness in generating sales Assesses effectiveness in generating sales from investments in all assetsfrom investments in all assets

Total Asset Turnover

Net salesNet sales

Total assetsTotal assets(Average)(Average)


5-5-3232

Activity RatiosActivity Ratios- - SummarySummaryReceivable Turnover Net Sales/Average Trade ReceivablesInventory Turnover COGS/Average InventoriesPayable Turnover Purchases/Average Trade PayablesFixed Asset Turnover Net Sales/Average PP&ETotal Asset Turnover Net Sales/Average Total Assets

Average collection period 365/receivable turnover Average days in inventory 365/inverntory turnoverAvergae payment period 365/payable turnover

Net Trade Period collection period + days in inventory -


5-5-3333

Activity RatiosActivity Ratios- - SummarySummaryActivity Ratios 2006 2005 2004Receivable Turnover 10,67 11,40 15,55 Inventory Turnover 4,98 6,08 6,57 Payable Turnover 14,21 13,90 25,24 PPE Turnover 0,96 0,91 0,98 Asset Turnover 0,60 0,58 0,63

Collection Period 34,21 32,00 23,47 Days in inventory 73,33 59,99 55,52 Payment period 25,68 26,26 14,46

Cash cycle 81,86 65,74 64,54


5-5-3434

Leverage Ratios: Leverage Ratios: Debt Financing and Debt Financing and CoverageCoverage

Considers the proportion of all assets Considers the proportion of all assets that are financed with debtthat are financed with debt

Debt Ratio

Total liabilitiesTotal liabilities

Total assetsTotal assets


5-5-3535

Leverage Ratios: Leverage Ratios: Debt Financing and Coverage Debt Financing and Coverage (cont.) (cont.)

Reveals the extent to which long-Reveals the extent to which long-term debt is used for the firm’s term debt is used for the firm’s permanent financing (both permanent financing (both long-term debt and equity)long-term debt and equity)

Long-term Debt to Total Capitalization

Long–term debtLong–term debt

Long-term debt + Stockholders’ Long-term debt + Stockholders’ equityequity


5-5-3636

Leverage Ratios: Leverage Ratios: Debt Financing and CoverageDebt Financing and Coverage

(cont.)(cont.)

Measures the riskiness of the firm’s Measures the riskiness of the firm’s capital structure in terms of the capital structure in terms of the relationship between the funds relationship between the funds supplied by creditors (debt) and supplied by creditors (debt) and investors (equity)investors (equity)

Debt to Equity

Total liabilitiesTotal liabilities

Stockholders’ equityStockholders’ equity


5-5-3737


(cont.)(cont.)

Indicates how well operating earnings Indicates how well operating earnings cover fixed interest expensescover fixed interest expenses

Times Interest Earned

Operating profitOperating profit

Interest expenseInterest expense


5-5-3838


(cont.)(cont.)

Measures how many times interest Measures how many times interest payments can be covered by payments can be covered by cash flow from operations cash flow from operations before interest and taxesbefore interest and taxes

Cash Interest Coverage

CFO + interest paid + taxes paidCFO + interest paid + taxes paid

Interest paidInterest paid


5-5-3939


(cont.)(cont.)

Broader measure of how well operating Broader measure of how well operating earnings cover fixed chargesearnings cover fixed charges

Fixed Charge Coverage

*Rent expense = operating lease payments

Operating profit + Rent expenseOperating profit + Rent expense

Interest expense + Rent expenseInterest expense + Rent expense


5-5-4040

Leverage Ratios: Leverage Ratios: Debt Financing and CoverageDebt Financing and Coverage (cont.)(cont.)

Measures firm’s ability to cover capital Measures firm’s ability to cover capital expenditures, long-term debt expenditures, long-term debt payments and dividends each yearpayments and dividends each year

Cash Flow Adequacy

Cash flow from operating activitiesCash flow from operating activities

Capital expenditures + debt Capital expenditures + debt repayments + dividends paidrepayments + dividends paid


5-5-4141

Leverage Ratios: Debt Financing Leverage Ratios: Debt Financing and Coverage Summaryand Coverage SummarySolvency RatiosDebt Ratio Total liabilities/Total assets LT Debt to CapitalDebt to equity Total liabilities/Total equity Times interest earned Oper. Income/Interest expense Cash interest coverage CFO + interest paid + tax paid)/Interest paid

Long-term Liquidity 2006 2005 2004Debt ratio 0,43 0,38 0,29 L/T Debt to Capitalization 0,29 0,26 0,19 debt to equity 0,83 0,67 0,43 Times interest earned 3,84 11,57 8,63 Cash Interest earned


5-5-4242

Profitability Ratios: Profitability Ratios: Overall Efficiency and Overall Efficiency and PerformancePerformance

Measures ability to translate sales Measures ability to translate sales into profit after consideration of into profit after consideration of cost of products soldcost of products sold

Gross Profit Margin

Gross profitGross profit

Net salesNet sales


5-5-4343

Profitability Ratios: Profitability Ratios: Overall Efficiency and PerformanceOverall Efficiency and Performance (cont.)(cont.)

Measures ability to translate sales Measures ability to translate sales into profit after consideration of into profit after consideration of operating expensesoperating expenses

Operating Profit Margin

Operating profitOperating profit

Net salesNet sales


5-5-4444


Measures ability to translate sales Measures ability to translate sales into profit after consideration into profit after consideration of all expenses and revenues, of all expenses and revenues, including interest, taxes and including interest, taxes and nonoperating itemsnonoperating items

Net Profit Margin

Net earningsNet earnings

Net salesNet sales


5-5-4545


Measures ability to translate sales into Measures ability to translate sales into cash (with which to pay bills!)cash (with which to pay bills!)

Cash Flow Margin

Cash flow from operating Cash flow from operating activitiesactivities

Net salesNet sales


5-5-4646


Measures overall efficiency of firm Measures overall efficiency of firm in managing investment in in managing investment in assets and generating profitsassets and generating profits

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


Total assetsTotal assets(Average)


5-5-4747

Relating the RatiosRelating the Ratios—The Du Pont System—The Du Pont System

Is helpful to complete the evaluation Is helpful to complete the evaluation of a firm by considering the of a firm by considering the interrelationship among the interrelationship among the individual ratios individual ratios


5-5-4848


(cont.)(cont.)

The Du Pont System helps the The Du Pont System helps the analyst see how the firm’s analyst see how the firm’s decisions and activities over decisions and activities over the course of an accounting the course of an accounting period interact to produce an period interact to produce an overall return to the firm’s overall return to the firm’s shareholders, the return on shareholders, the return on equity equity


5-5-4949


(cont.)(cont.)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 incomeNet income Net sales Net income

Net sales X Total assets = Total assetsNet sales X Total assets = Total assets

Net income Total assets Net Net income Total assets Net incomeincome

Total assets X Stockholder equity = Stockholder Total assets X Stockholder equity = Stockholder equityequity


5-5-5050


Measures rate of return on Measures rate of return on stockholders’ investmentstockholders’ investment

Return on Equity (ROE)


Stockholders’ equityStockholders’ equity(Average)


5-5-5151


Measures firm’s ability to generate Measures firm’s ability to generate cash from the utilization of its cash from the utilization of its assetsassets

Useful comparison to ROAUseful comparison to ROA

Cash Return on Assets

Cash flow from operating Cash flow from operating activitiesactivities

Total assetsTotal assets(Average)


5-5-5252

Profitability Ratios-SummaryProfitability Ratios-Summary

Profitability RatiosGross Margin Gross profit/Sales revenue Operating Margin Operating Income/Sales revenueNet Profit Margin Net Income/Sales RevenueReturn on Assets Net income/Average total assets Return on Equity Net income/Average total equity Cash Return on Assets CFO/Average total assets


5-5-5353

Profitability Ratios-SummaryProfitability Ratios-Summary

Profitability 2006 2005 2004Gross margin % 27,14% 27,80% 30,83%Operating Margin 10,99% 15,78% 18,61%Net Profit Margin 5,45% 9,98% 12,61%ROA = 3,25% 5,76% 7,94%ROE = 5,99% 9,37% 11,96%Cash Return on Assets 7,19% 16,58% 14,80%

A. Cam


5-5-5454

Market RatiosMarket Ratios

1.1. Earnings per common shareEarnings per common share2.2. Price-to-earningsPrice-to-earnings3.3. Dividend payoutDividend payout4.4. Dividend yieldDividend yield

Four market ratios of particular interest to the investor are


5-5-5555

Market RatiosMarket Ratios (cont.) (cont.)

Provides the investor with a Provides the investor with a common denominator to common denominator to gauge investment returnsgauge investment returns

Earnings per Common Share


Average shares outstandingAverage shares outstanding


5-5-5656


Relates earnings per common share to the Relates earnings per common share to the market price at which the stock trades, market price at which the stock trades, expressing the “multiple” that the stock expressing the “multiple” that the stock market places on a firm’s earningsmarket places on a firm’s earnings

Price-to-Earnings

Market price of common stockMarket price of common stock

Earnings per shareEarnings per share


5-5-5757


Determined by the formula cash Determined by the formula cash dividends per share divided by dividends per share divided by earnings per shareearnings per share

Dividend Payout

Dividends per shareDividends per share

Earnings per shareEarnings per share


5-5-5858


Shows the relationship between cash Shows the relationship between cash dividends and market pricedividends and market price

Dividend Yield

Dividends per shareDividends per share

Market price of common stockMarket price of common stock


5-5-5959

Market RatiosMarket Ratios

Market Ratios 2006 2005 2004Price earnings ratio 46,67 16,93 11,16price to book value 1,34 1,49 1,28

A. Cam


5-5-6060

Five Steps of a Financial Five Steps of a Financial Statement AnalysisStatement Analysis

Who are you and why are you Who are you and why are you interested in this company?interested in this company?

What questions would you like to What questions would you like to have answered?have answered?

What info is vital to the decision at What info is vital to the decision at hand? hand?

Establish objectives of the analysis

Step 1


5-5-6161

Five Steps of a Financial Five Steps of a Financial Statement AnalysisStatement Analysis (cont.)(cont.)

Study the industry in which the firm Study the industry in which the firm operates and relate industry operates and relate industry climate to current and projected climate to current and projected economic developments economic developments

Step 2Step 2


5-5-6262


How well does this firm appear to be run?How well does this firm appear to be run? Are they taking advantage of Are they taking advantage of

opportunities?opportunities? Are they innovative, forward-looking, etc?Are they innovative, forward-looking, etc?

Step 3

Develop knowledge of the firm and the quality of management


5-5-6363


Common-size financial statementsCommon-size financial statements Key financial ratiosKey financial ratios Trend analysisTrend analysis Structural analysisStructural analysis Comparison with industry competitorsComparison with industry competitors

Step 4

Evaluate financial statements–tools include:


5-5-6464


Short-term liquidityShort-term liquidity Operating efficiencyOperating efficiency Capital structure and long-term Capital structure and long-term

solvencysolvency ProfitabilityProfitability Market ratiosMarket ratios Segmental analysis (when relevant)Segmental analysis (when relevant) Quality of financial reportingQuality of financial reporting

Step 4 Evaluate financial statements–areas include:


5-5-6565


Reach conclusions about the Reach conclusions about the firm relevant to your firm relevant to your established objectives established objectives

Step 5

Summarize findings based on analysis


5-5-6666

What we have What we have accomplishedaccomplished

Auditor’s Report

Statement of Cash Flows

MD&A

Statement of Shareholders’ EquityBalance Sheet

Note

s

Inco

me S

tate

ment

TurnedMaze


5-5-6767

Financial StatementsFinancial StatementsAn OverviewAn OverviewMap

(c) 2007 prentice hall, inc.5-1 the analysis of financial statements ratios are tools and their...

Documents

prentice hall

analysis slide

management slide

financial tools

judgment slide

liquidation slide

financial statements

financial statement