Week 4

Financial Statements Analysis

Common Questions that F/S Analysis Can Help To Answer Creditor

Investor

Manager

Can the company pay the interest and principal on its debt? Does the company reply too much on non-owner financing?

Does the company earn an acceptable return on invested capital? Is the gross profit margin growing or shrinking? Does the company effectively use non-owner financing?

Are costs under control? Are the company’s markets growing or shrinking? Do observed changes reflect opportunities or threats? Is the allocation of investment across different assets too high or too low?

General Categories of Questions

SolvencyLiquidity

Earnings Potential

What we work with

Financial Statements Balance Sheet Income Statement Statement of Cash Flows

Other Parts of the 10K (Annual Report) MD&A Notes to the financial statements

Ratio Analysis

Examining various income statement and balance sheet components in relation to one another facilitates financial statement analysis. This type of examination is called ratio analysis.

Garbage In

At this point we will assume the numbers are worth using without adjustment

Generally this is not a good assumption for a lot of analysis

Apples to applesPersistent and transitory

Some Limitations of Ratio analysis

What is Good?

The company earned $2,000,000 Does that mean it had a good year? Does management deserve a big bonus? Would you, as a shareholder, be happy? How about the lenders?

Financial Statement Analysis

Across timeWithin industryWithin firm

Common size statements Ratio analysis

Comparisons Within the Financial StatementsCommon-size financial statements

(vertical analysis) Compare to a base amount

Ratio analysis Profitability ratios – Earnings potential Solvency and Liquidity ratios – Ability to pay

creditors Asset Management Ratios (Turnover) -

Efficiency Market ratios – Stock price versus accounting

Profitability Analysis

Return on Assets (ROA):

ROA = Net Income / Total Assets

For example, if we invest $100 in a savings account yielding $3 at year-end, the return on assets is 3%.

Disaggregating Return on Assets

Profit Margin, Asset Turnover, and Return on Assets for Selected Industries

Gross Profit Margin

It allows a focus on average unit mark-ups A high gross profit margin is preferred to a

lower one, which also implies that a company has relatively more flexibility in product pricing.

Competition and product mix will affect it

Turnover

Turnover measures relate to the productivity of company assets. Such measures seek to answer the amount of capital required to generate a specific sales volume.

As turnover increases, there is less need for cash since cash outflow for assets to support the current sales volume is reduced.

Turnover ratios

Total assets Sales / Assets

Accounts receivable Sales / A/R

Inventory COGS / Inventory

Accounts Payable COGS / A/P

Turnover ratios

To convert turnovers to a period number divide into 365

Cash collection cycle

ROE Analysis Structure

Return on Equity

Return on equity (ROE) is computed as:

ROE = Net Income / Average Equity

Financial Leverage and RiskLEV is the other component of

ROEIs Debt a bad thing?Given that increases in financial

leverage increase ROE, why are all companies not 100% debt financed?

Leverage and Income Variability

Liquidity and Solvency Measures

Liquidity refers to cash: how much we have, how much is expected, and how much can be raised on short notice.

Solvency refers to the ability to meet obligations; primarily obligations to creditors, including lessors.

Current Ratio

Current ratio is simply current assets divided by current liabilities.

If we subtracted rather than divided we would have working capital

A very rough gauge of the ability to service short-term obligations.

What is a good number?

Quick Ratio

A refinement of the current ratio.Rather then using all current assets in the

numerator, we limit it to cash, marketable securities, and accounts receivable.

Why?

Solvency

Some combination of debt divided by either total assets or stockholders’ equity Long-term debt to assets Long-term debt to shareholders’ equity Total debt to assets Total debt to shareholders’ equity

Times interest earned

EBIT divided by interest expense

Vertical and Horizontal Analysis

Vertical and Horizontal Analysis