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FINANCIAL STATEMENT ANALYSIS
CHAPTER 13
Fundamental Analysis
Finance (chapter 12): Valuation techniques Dividend discount model, P/E ratio Need input as dividends and earnings prospects
Economics (chapter 11) (information from outside) macro level: market micro level: industries, firms
Accounting (chapter 13) (information from inside) How to read reported data? How to use financial data as inputs into stock valuation
Financial Statement AnalysisFinancial Statement Analysis
Objectives:
• Use a firm’s income statement, balance sheet, and statement of cash flows to calculate standard financial ratios.
• Calculate the impact of taxes and leverage on a firm’s return on equity using ratio decomposition analysis.
• Measure a firm’s operating efficiency
• Identify likely sources of biases in accounting data.
Income Statement
Firm’s revenues and expenses during a specific period Typical formatSale
- Operating expense
COGS
Depreciation
Operating Income (EBIT)
- Interest
Earning before tax (EBT)
- Tax
Net Income (NI)
Table 14.1 Consolidated Statement of Income
Balance Sheet
A snapshot of firm’s assets and liability at a given point in time
Asset Liabilities + Equity
1. Current Asset 1. Current liabilities
Cash Short term debt
Account receivable Account payable
Inventory Note payable
2. Fixed asset 2. Long-term debt
3. Equity
Common stock
Retained earning
Total assets Total liabilities + equity
Table 14.2 Consolidated Balance Sheet
Statement of cash flow
Net income: accounting profit Cash flow: cash available on hand Statement of cash flow: firm’s cash receipts and payments
during a specific period
Table 14.3 Consolidated Statement of Cash Flows
Return on Equity (ROE)
ROE=Net profit/Equity g = ROE × b To estimate g, need to estimate ROE Past ROE might not be good estimator of future ROE ROE is linked with ROA and affected by firm’s financial
policies Watch out financial leverage:
ROA: Return on Assets=EBIT/Assets
Equity
DebtteInterestRaROAROATaxRateROE )()1(
ROE = Net Profit
Pretax Profit
x
Pretax Profit
EBITx
EBIT
Sales
Sales
Assetsx x
Assets
Equity
(1) x (2) x (3) x (4) x (5)
x Margin x Turnover x Leverage Tax
Burden
Interest
Burden
Du Pont System: Decomposition of ROE
x
Problem 7, Chapter 13, P. 456
An analyst applies the DuPont system of financial analysis to the following data for a company:
Leverage ratio 2.2
Total asset turnover 2.0
Net profit margin 5.5%
Dividend payout ratio 31.8%
What is the company’s return on equity?
Ratio analyses
Liquidity Ratios Activity or Mgmt Efficiency Ratios Leverage Ratios Profitability Ratios Market Price Ratios
2002 2003 2004 2005Income statements
Sale revenue 100,000 120,000 144,000Cost of goods sold 55,000 66,000 79,200Depreciation 15,000 18,000 21,600Selling and administrative expenses 15,000 18,000 21,600Operating income 30,000 36,000 43,200Interest expense 10,500 19,095 34,391Taxable income (40% tax rate) 7,800 6,762 3,524Net Income 11,700 10,143 5,285
Balance Sheet (end of year)Cash and marketable securities 50,000 60,000 72,000 86,400Account receivables 25,000 30,000 36,000 43,200Inventories 75,000 90,000 108,000 129,600Net plant and equipment 150,000 180,000 216,000 259,200Total Asset 300,000 360,000 432,000 518,400Account payable 30,000 36,000 43,200 51,840Short-term debt 45,000 87,300 141,957 214,432Long-term debt 75,000 75,000 75,000 75,000Total Liabilities 150,000 198,300 260,157 341,272Shareholders’equity (1 mil shares outstanding) 150,000 161,700 171,843 177,128Market price per common share at year-end 93.60 61.00 21.00
Liquidity ratios
Current ratio = Current asset/ current liabilities
2003: current ratio = (60+30+90)/(36+87.3) = 1.462003 2004 2005 2005 industry average (IA)
1.46 1.17 0.97 2.0 Trend: decreasing poor standing relative to industry
Quick ratio = (current asset-inventory)/current liability
2003: quick ratio = (60+30)/(36+87.3) = 0.732003 2004 2005 2005 industry average (IA)
0.73 0.58 0.49 1.0 Trend: decreasing poor standing relative to industry
Management efficient ratios
Inventory turnover = COGS (excluding depreciation) / average inventory How fast firm can sell inventory 2003: inventory turnover = (55-15)/{(75+90)/2)}= 0.485 2003 2004 2005 IA
0.485 0.485 0.485 0.5 Slower in selling inventory
total asset turnover = sale/average total asset 2003: TA turnover = 100/((300+360)/2) = 0.30 2003 2004 2005 IA
0.30 0.30 0.30 0.4
Management efficient ratios
Average collection period (days receivable)
= average AR/sales per day average time between date of sale and date payment received 2003: {(25+30)/2}/(100/365) = 100.4 2003 2004 2005 IA
100.4 100.4 100.4 60 fixed asset turnover = sale/average of fixed asset
2003: 100/{(150+180)/2}=0.600 2003 2004 2005 IA
0.606 0.606 0.606 0.7
Some comments on efficient management ratios
Total asset turnover of G.I. < industry average (0.3<0.4) fixed asset turnover < Industry average (0.60 < 0.7): inefficient in
using fixed asset days receivable > industry average (100.4 > 60): receive cash longer
than average, poor receivable procedure Inventory turnover < industry average (0.485<0.5): turn inventory into
sale slower than average, poor inventory management
Leverage ratios
Interest coverage (times interest earned) = EBIT/Interest expense
Leverage ratio:
Assets/Equity = 1 + Debt/Equity Debt ratio = debt/equity
Profitability ratios
ROA = EBIT/(average total assets) ROE = NI/(average total equity) Return on sale (profit margin) = EBIT/Sales
Market price ratios
Market-to-book = price per share/ book value per share Lower market-to-book stocks: safer stocks
Price-to-earning (P/E) = market price per share / EPS Low P/E, more bargain
Comparability Problems GAAP (Generally Accepted Accounting Principles) is
not unique Inventory valuation: LIFO vs FIFO Depreciation: Straight line vs Accelerated
Quality of earnings affected by: Allowance of bad debt; nonrecurring items; stock
option; revenue recognition; off-balance-sheet assets and liabilities
GAAP vs IAS (International Accounting Standards)
Quality of Earnings:Areas of Accounting ChoicesQuality of Earnings:Areas of Accounting Choices
Allowance for bad debts: When companies sell goods using credit, need to have allowance for bad debts. This is the estimate.
Different companies have different estimates
Non-recurring items: Unusual income, does not happen regularly.
Reserves management: Different companies have different estimates of reserve for future investment
Stock options Companies use stock options as bonus therefore it should be reported as expenses and need to price the
options
Revenue recognition Off-balance sheet assets and liabilities
Figure 13.3 Adjusted Versus Reported Price-Earnings Ratios