Ch. 8

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Ch. 8

  1. 1. Analysis of Financial Statements Chapter 8
  2. 2. Financial Statement Analysis <ul><li>Involves </li></ul><ul><ul><li>Comparing firm’s performance with others in same industry </li></ul></ul><ul><ul><li>Evaluating trends in the firm’s financial position over-time </li></ul></ul><ul><li>Managers want to estimate effect of actions </li></ul><ul><li>Accounting </li></ul><ul><ul><li>Keeps “score” </li></ul></ul><ul><ul><li>Does not address stock price impact </li></ul></ul><ul><ul><li>INTERPRET not make </li></ul></ul>
  3. 3. Ratio Analysis <ul><li>Standardize numbers </li></ul><ul><li>Facilitate comparison </li></ul><ul><ul><li>different sizes </li></ul></ul><ul><li>Highlight (red flag) </li></ul><ul><ul><li>strengths </li></ul></ul><ul><ul><li>weaknesses </li></ul></ul><ul><li>Anticipate future </li></ul><ul><li>Planning starting point </li></ul>
  4. 4. Ratio Analysis <ul><li>Consider </li></ul><ul><ul><li>What aspects are we analyzing? </li></ul></ul><ul><ul><li>What goes into a particular ratio? </li></ul></ul><ul><ul><li>What is unit of measure? </li></ul></ul><ul><ul><li>What is the benchmark? </li></ul></ul>
  5. 5. Ratio Categories and Purposes <ul><li>Liquidity </li></ul><ul><ul><li>Can we make required payments? </li></ul></ul><ul><li>Asset management </li></ul><ul><ul><li>Right amount for sales </li></ul></ul><ul><li>Debt management </li></ul><ul><ul><li>Right mix of debt and equity </li></ul></ul><ul><li>Profitability </li></ul><ul><ul><li>How efficiently firms uses assets and manages operations </li></ul></ul><ul><li>Market value </li></ul><ul><ul><li>Investor beliefs </li></ul></ul>
  6. 6. Ratio Example: BUD <ul><li>Liquidity </li></ul><ul><ul><li>Current Ratio Current Assets/Current Liabilities = ? </li></ul></ul><ul><ul><li>Quick Ratio (CA - Inv)/CL = ? </li></ul></ul><ul><ul><li>Consider together </li></ul></ul><ul><ul><li>Why inventory? </li></ul></ul>
  7. 7. Ratio Example: BUD <ul><li>Asset Management </li></ul><ul><ul><li>Inventory Turnover Sales/Inventories =? </li></ul></ul><ul><ul><li>Days Sales Outstanding Receivables/Avg. Sales Per Day = Receivables/(Sales/360) = ? </li></ul></ul>
  8. 8. Ratio Example: BUD <ul><li>Others </li></ul><ul><ul><li>Fixed Assets Turnover Ratio </li></ul></ul><ul><ul><ul><li>Sales/Net Fixed Assets </li></ul></ul></ul><ul><ul><li>Total Assets Turnover Ratio </li></ul></ul><ul><ul><ul><li>Sales/Total Assets </li></ul></ul></ul><ul><li>Which one is best? </li></ul>
  9. 9. Ratio Example: BUD <ul><li>Debt Management </li></ul><ul><ul><li>Financial leverage </li></ul></ul><ul><ul><ul><li>If firms earns more on investments financed thru debt than it pays in interest, the return on capital is magnified or leveraged </li></ul></ul></ul><ul><ul><ul><li>Balance higher expected returns and risk </li></ul></ul></ul><ul><ul><li>Debt Ratio Total Debt/Total Assets = ? </li></ul></ul>
  10. 10. Ratio Example: BUD <ul><ul><li>Times Interest Earned EBIT/Int. Exp. = ? </li></ul></ul><ul><li>Profitability </li></ul><ul><ul><li>Profit Margin on Sales </li></ul></ul><ul><ul><ul><li>Net income available for common/Sales </li></ul></ul></ul><ul><ul><li>Basic Earning Power </li></ul></ul><ul><ul><ul><li>EBIT/Total Assets </li></ul></ul></ul>
  11. 11. Ratio Example: BUD <ul><ul><li>Return on Assets Net Income/Total Assets = ? </li></ul></ul><ul><ul><li>Return on Equity Net Income/Common Equity = ? </li></ul></ul><ul><ul><li>Common -- but problems? </li></ul></ul><ul><ul><li>Debt? </li></ul></ul><ul><ul><ul><li>Int exp lowers NI, so ROA decreases </li></ul></ul></ul><ul><ul><ul><li>Debt also lowers equity, but if equity lowered more than NI, ROE increases </li></ul></ul></ul>
  12. 12. More on profitability ratios <ul><li>Example: If firm improves ROE does EVA improve? </li></ul><ul><ul><li>Correlated but </li></ul></ul><ul><ul><ul><li>ROE ignores risk </li></ul></ul></ul><ul><ul><ul><li>ROE does not consider amount of invested capital </li></ul></ul></ul><ul><ul><ul><li>ROE goals can lead managers to do the wrong thing </li></ul></ul></ul><ul><li>Need to combine project’s return with risk and size to determine effect on s/h wealth </li></ul><ul><ul><li>ROE – just return </li></ul></ul>
  13. 13. Ratio Example: BUD <ul><li>Market Value Ratios </li></ul><ul><ul><li>Price/Earnings Ratio (P/E) Price Per Share/Earnings Per Share </li></ul></ul><ul><ul><ul><li>High or low? </li></ul></ul></ul><ul><ul><ul><li>How comparable? </li></ul></ul></ul><ul><ul><li>Market-to-Book Ratio Market Price Per Share/Book Value Per Share where BVPS = Common Equity/Shares Outstanding </li></ul></ul><ul><ul><ul><li>Proxy for growth </li></ul></ul></ul>
  14. 14. Ratio Example: BUD <ul><li>What do we mean by book value? </li></ul><ul><ul><li>Book Value = Money that has been paid in to the firm by stockholders or retained by the firm </li></ul></ul><ul><ul><li>Market Value is the present value of all of the cash flows that are expected to accrue to the shareholders into the future </li></ul></ul><ul><li>Why does BV not equal MV? </li></ul><ul><ul><li>BV is the amount of capital that has been paid in over time (historical figure--backward looking) </li></ul></ul><ul><ul><li>MV is the present value of all of the expected future cash flows (forward looking) </li></ul></ul>
  15. 15. Effect of Changes <ul><li>What happens if DSO reduced to 18 days? </li></ul><ul><ul><li>When 23.2 days </li></ul></ul><ul><ul><ul><li>Receivables = Averages Sales Per Day x DSO </li></ul></ul></ul><ul><ul><ul><li>Average Sales Per Day = 30.739 </li></ul></ul></ul><ul><ul><ul><li>Receivables = 713.14 </li></ul></ul></ul><ul><ul><li>When 18 days </li></ul></ul><ul><ul><ul><li>Average Sales Per Day = 30.739 </li></ul></ul></ul><ul><ul><ul><li>Receivables = 553.30 </li></ul></ul></ul>
  16. 16. Effect of Changes <ul><ul><li>Cash!!!! </li></ul></ul><ul><ul><ul><li>What can we do with it? </li></ul></ul></ul><ul><ul><ul><ul><li>Repurchase stock </li></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>Higher ROE and EPS </li></ul></ul></ul></ul></ul><ul><ul><ul><ul><li>Expand </li></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>Higher profits </li></ul></ul></ul></ul></ul><ul><ul><ul><ul><li>Reduce debt </li></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>Better debt ratio, lower interest expense, higher net income </li></ul></ul></ul></ul></ul><ul><ul><ul><li>Impact on stock price? </li></ul></ul></ul>
  17. 17. DuPont System <ul><li>Shows how ROE is affected by </li></ul><ul><ul><li>________ efficiency (profit margin) </li></ul></ul><ul><ul><li>________ efficiency (turnover) </li></ul></ul><ul><ul><li>Financial _______ (equity multiplier) </li></ul></ul><ul><li>Decompose ROE </li></ul><ul><ul><li>ROE = Net Income/Common Equity = Net Income/Common Equity x Total Assets/Total Assets = Net Income/Total Assets x Total Assets/Total Equity = ROA x Equity Multiplier </li></ul></ul>
  18. 18. DuPont System <ul><li>Decompose ROA </li></ul><ul><ul><li>ROA = Net Income/Total Assets = Net Income/Total Assets x Sales/Sales = Net Income/Sales x Sales/Total Assets = Profit Margin x Total Asset Turnover </li></ul></ul><ul><li>DuPont Identity </li></ul><ul><ul><li>ROE = Profit Margin x Total Asset Turnover x Equity Multiplier </li></ul></ul>
  19. 19. Ratio Analysis <ul><li>Who uses? </li></ul><ul><ul><li>Internal </li></ul></ul><ul><ul><li>Creditors </li></ul></ul><ul><ul><li>Potential investors/analysts </li></ul></ul><ul><li>Must have benchmark </li></ul><ul><ul><li>Time series </li></ul></ul><ul><ul><li>Peer group </li></ul></ul>
  20. 20. Ratio Analysis <ul><li>Problems </li></ul><ul><ul><li>Defining peers/benchmarks </li></ul></ul><ul><ul><li>Average performance is not necessarily good </li></ul></ul><ul><ul><li>Conglomerates </li></ul></ul><ul><ul><li>Accounting practices </li></ul></ul><ul><ul><li>Historical data </li></ul></ul><ul><ul><li>Seasonal variation/one-time events </li></ul></ul><ul><ul><li>Window dressing </li></ul></ul><ul><ul><li>Mixed signals </li></ul></ul>
  21. 21. Times Series for Anheuser-Busch <ul><li>Ratio definitions from Compustat PC Plus </li></ul><ul><li>Examine/compare/look for trends </li></ul><ul><ul><li>Liquidity </li></ul></ul><ul><ul><li>Turnover </li></ul></ul><ul><ul><li>Profitability </li></ul></ul><ul><ul><li>Leverage </li></ul></ul><ul><ul><li>Market </li></ul></ul>
  22. 22. Times Series for Anheuser-Busch Ratio Category: _____________ Strengths Weaknesses Interesting
  23. 23. Cross-Sectional Analysis <ul><li>Peer group </li></ul><ul><ul><li>Strengths? </li></ul></ul><ul><ul><li>Weaknesses? </li></ul></ul><ul><li>Compare </li></ul><ul><ul><li>Liquidity </li></ul></ul><ul><ul><li>Turnover </li></ul></ul><ul><ul><li>Profitability </li></ul></ul><ul><ul><li>Leverage </li></ul></ul><ul><ul><li>Market </li></ul></ul>
  24. 24. Cross-Sectional Analysis Ratio Category: _____________ Strengths Weaknesses Interesting
  25. 25. Common Size Statements <ul><li>For balance sheet </li></ul><ul><ul><li>LHS: divide all items by total assets </li></ul></ul><ul><ul><li>RHS: divide all items by total liabilities and equity </li></ul></ul><ul><li>For income statement </li></ul><ul><ul><li>Divide all items by sales </li></ul></ul><ul><li>For percentage change analysis </li></ul><ul><ul><li>Find percentage change from first year </li></ul></ul>
  26. 26. Financial Statement Analysis <ul><li>Would you invest in one or more of them? </li></ul><ul><li>Would you loan to them? </li></ul><ul><li>What should Petes do differently? </li></ul>
  27. 27. Market Efficiency and Financial Statement Analysis <ul><li>What does Efficient Market Hypothesis imply regarding the validity of financial statement analysis? </li></ul><ul><li>Does ratio analysis provide any value? </li></ul><ul><ul><li>From beginning </li></ul></ul><ul><ul><ul><li>Standardize numbers? </li></ul></ul></ul><ul><ul><ul><li>Facilitate comparison? </li></ul></ul></ul><ul><ul><ul><li>Highlight strengths and weaknesses? </li></ul></ul></ul><ul><ul><ul><li>Anticipate future? </li></ul></ul></ul><ul><ul><ul><li>Planning starting point? </li></ul></ul></ul>

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