chapter 11 analysis of financial statements. 1.2 investments chapter 11 chapter 11 questions...

Chapter 11Chapter 11

ANALYSIS OF FINANCIAL STATEMENTS

1.2Investments Chapter 11

Chapter 11 Questions

Questions to be answered: What are the major financial statements provided by firms

and what specific information does each of them contain? Why do we use financial ratios to examine the performance

of a firm, and why is it important to examine performance relative to the economy and to a firm’s industry?



What are the major categories for financial ratios and what questions are answered by the ratios in these categories?

What specific ratios help determine a firm’s internal liquidity, operating performance, risk profile, and growth potential?

How can the DuPont analysis help evaluate a firm’s past and future return on equity?



What is a quality balance sheet or income statement? Why is financial statement analysis done if markets are

efficient and forward-looking? What major financial ratios help analysts in the following

areas: stock valuation, estimating and evaluating systematic risk, predicting the credit ratings on bonds, and predicting bankruptcy?


Analyzing Financial Statements

We will be considering asset valuation. Financial asset values are a function of two

variables:Discount rate ( the required rate of return)Expected future cash flows

Financial statement analysis can be useful in estimating both of these valuation inputs.


Major Financial Statements

Corporate shareholder annual and quarterly reports must include:Balance sheetIncome statementStatement of cash flows

Reports filed with Securities and Exchange Commission (SEC)10-K and 10-Q


Generally Accepted Accounting Principles

GAAP are formulated by the Financial Accounting Standards Board (FASB)

Provides some flexibility of accounting principlesCan be good for firms in different situationsCan represent a challenge for analysisFinancial statements footnotes must disclose which

accounting principles are used by the firm


Balance Sheet

Shows resources (assets) of the firm and how it has financed these resources

Indicates current and fixed assets available at a point in time

Financing is indicated by its mixture of current liabilities, long-term liabilities, and owners’ equity


Income Statement

Contains information on the profitability of the firm during some period of time

Indicates the flow of sales, expenses, and earnings during the time period


Statement of Cash Flows

Integrates the information on the balance sheet and income statement

Shows the effects on the firm’s cash flow of income statement items and changes in various items on the balance sheet

Three sections show cash flows fromOperating activitiesInvesting activitiesFinancing activities


Alternative Measures of Cash Flow

Cash flow from operationsTraditional cash flow equals net income plus depreciation

expense and deferred taxesAlso adjust for changes in operating assets and liabilities

that use or provide cash Free cash flow recognizes that some investing and financing

activities are critical to ongoing success of the firmModifies cash flow from operations to reflect necessary

capital expenditures and projected divestitures


Alternative Measures of Cash Flow

EBITDAEarnings Before Interest, Taxes, Depreciation, and

AmortizationA more generous measure of operating earnings, since all of

these items are added backPerhaps a somewhat questionable measure of actual

operating performance


Purpose of Financial Statement Analysis

Evaluate management performance inProfitabilityEfficiencyRisk

Although financial statement information is historical, it is used to project future performance


Analysis of Financial Ratios

Ratios can often be more informative that raw numbersPuts numbers in perspective with other numbersHelps control for different sizes of firms

Ratios provide meaningful relationships between individual values in the financial statements


Importance of Relative Financial Ratios

In order to make sense of a ratio, we must compare it with some appropriate benchmark or benchmarks

Examine a firm’s performance relative to:The aggregate economyIts industry or industriesIts major competitors within the industryIts own past performance (time-series analysis)


Comparing to the Aggregate Economy

Most firms are influenced by economic expansions and contractions in the business cycle

Analysis helps you estimate the future performance of the firm during subsequent business cycles


Comparing to the Industry Norms

Most popular comparison Industries affect the firms within them differently, but the

relationship is always significant The industry effect is strongest for industries with

homogenous products Can also examine the industry’s performance relative to

aggregate economic activity


Comparing to the Firm’s Major Competitors

Industry averages may not be representative A firm may operate in several distinct industries Several approaches:

Select a subset of competitors for the comparison groupConstruct a composite industry average from the different

industries in which the firm operates


Comparing to the Firm’s Own Past Performance Determine whether it is progressing or declining Helpful for estimating future performance Consider trends as well as averages over time


Five Categories of Financial Ratios

1. Common size statements2. Internal liquidity (solvency)3. Operating performance

Operating efficiency Operating profitability

4. Risk analysis Business risk Financial risk External liquidity risk

5. Growth analysis


Common Size Statements

Normalize balance sheets and income statement items to allow easier comparison of different size firms

A common size balance sheet expresses accounts as a percentage of total assets

A common size income statement expresses all items as a percentage of sales


Evaluating Internal Liquidity

Internal liquidity (solvency) ratios indicate the ability to meet future short-term financial obligations

Current Ratio examines current assets and current liabilities

sLiabilitieCurrent

AssetsCurrent RatioCurrent



Quick Ratio adjusts current assets by removing less liquid assets

sLiabilitieCurrent

sReceivableSecurities MarketableCashRatioQuick



Cash ratio relates cash (ultimate liquid asset) to current liabilities

sLiabilitieCurrent

Securities MarketableCashRatioCash



Receivables turnover examines the management of accounts receivable

sReceivable Average

Sales AnnualNet Turnover sReceivable

Receivables turnover can be converted into an average collection period

Turnover Annual

365Period Collection sReceivable Average



Inventory turnover relates inventory to sales or cost of goods sold (CGS)

Inventory Average

Sold Goods ofCost TurnoverInventory

Given the turnover values, you can compute the average inventory processing time

Turnover Annual

365Period ProcessingInvetory Average



Cash conversion cycle combines information from the receivables turnover, inventory turnover, and accounts payable turnover

CCC = Receivables Collection Period + Inventory Processing Period - Payables Payment Period


Evaluating Operating Performance

Ratios that measure how well management is operating a businessOperating efficiency ratios

Examine how management uses its assets to generate sales; considers the relationship between various asset categories and sales

Operating profitability ratiosExamine how management is doing at controlling costs so

that a large proportion of the sales dollar is converted into profit


Operating Efficiency Ratios

Total asset turnover ratio indicates the effectiveness of a firm’s use of its total asset base to produce sales

AssetsNet Total Average

SalesNet TurnoverAsset Total


Operating Efficiency Ratios

Net fixed asset turnover reflects utilization of fixed assets

This number can look temporarily bad if the firm has recently added greatly to its capacity in anticipation of future sales

Assets FixedNet Average

SalesNet TurnoverAsset Fixed


Operating Profitability Ratios

Operating profitability ratios measureThe rate of profit on sales

(profit margin)The percentage return on

capital



Gross profit margin measures the rate of return after cost of goods sold

What proportion of the sales dollar is left after cost of goods sold?Is the firm buying inputs (inventory and direct labor) at

good prices?

SalesNet

Profit GrossMarginProfit Gross



Operating profit margin measures the rate of profit on sales after operating expensesOperating profit is sometimes called Earnings before

interest and taxes (EBIT)Operating income can be thought of as the “bottom

line” from operations

SalesNet

Profit OperatingMarginProfit Operating



Net profit margin relates net income to salesShows the combined effect of operating profitability

and the firm’s financing decisions (since net income is after interest and tax payments)

SalesNet

IncomeNet MarginProfit Net


Common Size Income Statement

Since Net Sales is in the denominator of all of the three previous ratios, the common size income statement gives all of these ratios at onceIt also allows us to focus on any categories of

expenses that are out of line with the appropriate benchmark



Return on total capital relates the firm’s earnings to all capital invested in the business

Capital Total Average

ExpenseInterest IncomeNet Capital Totalon Return



Consideration of Lease ObligationsLeases for assets are economically similar to debt

obligations, but have different accounting treatmentMay want to capitalize operating leases in order to get a

more accurate measure of assets and financingShould also consider the implied interest and depreciation

for leases when including the impact of leases on the Return on total capital



Return on owner’s equity (ROE) indicates the rate of return earned on the capital provided by the stockholders after paying for all other capital used

Equity Total Average

IncomeNet Equity Totalon Return



Return on owner’s equity (ROE) can be computed for the based only on the common shareholder’s equityDeducts preferred dividends, which are a priority claim

on net income

EquityCommon Average

Dividend Preferred-IncomeNet Equity sOwner'on Return



The DuPont System divides ROE into several ratios that collectively equal ROE while individually providing insight

EquityCommon

SalesNet

SalesNet

IncomeNet

EquityCommon

IncomeNet ROE

Equity

Assets Total

Assets Total

Sales

Equity

Sales



EquityCommon

Assets Total

Assets Total

Sales

Sales

IncomeNet

EquityCommon

IncomeNet

Profit Total Asset Financial

Margin Turnover Leverage= xx



An extended DuPont System provides additional insights into the effect of financial leverage on the firm and pinpoints the effect of income taxes on ROE


Risk Analysis

Risk analysis examines the uncertainty of income for the firm and for an investor

Total firm risks can be decomposed into two basic sources:Business risk: The uncertainty in a firm’s operating income,

highly influenced by industry factorsFinancial risk: The added uncertainty in a firm’s net income

resulting from a firm’s financing decisions (primarily through employing leverage).

External liquidity analysis considers another aspect of risk from an investor’s perspective


Business Risk

Variability of the firm’s operating income over time Can be measured by calculating the standard

deviation of operating income over time or the coefficient of variation

In addition to measuring business risk, we want to explain its determining factors.


Business Risk

Two primary determinants of business risk Sales variability

The main determinant of earnings variability Cost Variability and Operating leverage

Production has fixed and variable costsGreater fixed production costs cause greater profit volatility

with changes in salesFixed costs represent operating leverageGreater operating leverage is good when sales are high and

increasing, but bad when sales fall


Financial Risk

Interest payments are deducted before we get to net incomeThese are fixed obligations

Similar to fixed production costs, these lead to larger earnings during good times, and lower earnings during a business declineFixed financing costs are called financial leverage

The use of debt financing increases financial risk and possibility of default while increasing profitability when sales are high


Financial Risk

Two sets of financial ratios help measure financial riskBalance sheet ratiosEarnings or cash flow available to pay fixed financial

charges Acceptable levels of financial risk depend on

business riskA firm with considerable business risk should likely

avoid lots of debt financing


Financial Risk

Proportion of debt (balance sheet) ratios Long-term debt can be related to:

Equity (L-t D/Equity)How much debt does the firm employ in relation to its use of

equity?Total Capital [L-t D/(L-t D +Equity)]

How much debt does the firm employ in relation to all long-term sources of funds?

Total debt can be related to:Total Capital [Total Debt/(Ttl. Liab.–Non-int. Liab.)]

Assessment of overall debt load, including short-term


Financial Risk

Earnings or Cash Flow RatiosRelate operating income (EBIT) to fixed payments

required from debt obligationsHigher ratio means lower risk


Financial Risk

Interest Coverage or Times Interest Earned Ratio Measures the number of times Interest payments are

“covered” by EBIT

Interest Coverage = EBIT/Interest Expense

May also want to calculated coverage ratios that reflect other fixed chargesLease obligations (Fixed charge coverage)


Financial Risk

Cash flow ratiosFixed financing costs such as interest payments must be

paid in cash, so these ratios use cash flow rather than EBIT to assess the ability to meet these obligations

Relate the flow of cash available from operations to:Interest expenseTotal fixed chargesThe face value of outstanding debt


External Liquidity Risk

Market Liquidity is the ability to buy or sell an asset quickly with little price change from a prior transaction assuming no new information

External market liquidity is a source of risk to investors


External Liquidity Risk

The most important factor of external market liquidity is the dollar value of shares tradedThis can be estimated from the total market value of

outstanding securitiesIt will be affected by the number of security owners

Numerous buyers and sellers provide liquidity


Analysis of Growth Potential

Want to determine sustainable growth potentialImportant to both creditors and owners

Creditors interested in ability to pay future obligationsFor owners, the value of a firm depends on its future growth

in earnings, cash flow, and dividends


Determinants of Growth

Sustainable Growth ModelSuggests that the sustainable growth rate is a function of

two variables: What is the rate of return on equity (which gives the maximum

possible growth)?How much of that growth is put to work through earnings retention

(rather than being paid out in dividends)?g = ROE x Retention rate

The retention rate is one minus the firm’s dividend payout ratioAnything that impacts ROE would also be a determinant of future

growth


Determinants of Growth

ROE (recall the DuPont equation) is a function ofNet profit marginTotal asset turnoverFinancial leverage (total assets/equity)


Analysis of Non-U.S. Financial Statements

Statement formats will be different Differences in accounting principles Ratio analysis will reflect local accounting

practices


The Quality of Financial Statements

“Quality financial statements” reflect reality rather than use accounting tricks or one-time adjustments to make things look better than they are



High-quality balance sheets typically have Conservative use of debtAssets with market value greater than bookNo liabilities off the balance sheet



High-quality income statements Reflect repeatable earnings

Gains from nonrecurring items should be ignored when examining earnings

High-quality earnings result from the use of conservative accounting principles that do not overstate revenues or understate costs


The Value of Financial Statement Analysis

Financial statements, by their nature, are backward-looking An efficient market will have already incorporated these past

results into security prices, so why analyze the statements?Analysis provides knowledge of a firm’s operating and

financial structureThis aids in estimating future returns


Uses of Financial Ratios

Stock valuation Identification of corporate variables affecting a

stock’s systematic risk (beta) Assigning credit quality ratings on bonds Predicting insolvency (bankruptcy) of firms


Financial Ratios and Stock Valuation Models

Stock valuation often considers discounted cash flow analysisEstimate cash flowsEstimate an appropriate discount rate

A number of financial ratios can be useful in arriving at estimates for each of these inputs

Price ratio analysis for a stockSometimes we estimate the value of a stock through various

price ratios such as P/EWould need to estimate variables such as expected growth rate of

earnings and dividends


Financial Ratios and Systematic Risk

A firm’s systematic risk (as measured by beta) is related to a number of financial statement variables


Financial Ratios and Bond Ratings

Changes in bond ratings are linked to changes in various financial statement variablesPredicting such changes in ratings before they occur

can increase the return on a bond or stock portfolio


Financial Ratios and Insolvency (Bankruptcy)

Certainly, analysts and investors are concerned with the possibility of bankruptcyA number of variables have a rather strong relationship

to the bankruptcy experience of firms in the pastCan use financial statement analysis to identify firms

where insolvency is a likely outcomes


Limitations of Financial Ratios

Always consider relative financial ratios Accounting treatments may vary among firms, especially

among non-U.S. firms Firms may have have divisions operating in different

industries making it difficult to derive industry ratios Are the results consistent? Ratios outside an industry range may be cause for concern

chapter 11 analysis of financial statements. 1.2 investments chapter 11 chapter 11 questions...

Documents

investments chapter

major financial ratios

q slide

time period slide

questions questions

financial asset values

owners equity slide

quality balance sheet