Major Financial Statements <ul><li>Corporate shareholder annual and quarterly  reports must include </li></ul><ul><ul><li>...
Statement of Cash Flows <ul><ul><li>It has three sections: </li></ul></ul><ul><ul><li>Cash Flow from Operating Activities ...
Importance of  Relative Financial Ratios <ul><li>Compare to other entities </li></ul><ul><li>Examine a firm’s performance ...
Comparing to  A Firm’s Industry <ul><li>Most popular comparison </li></ul><ul><li>Industries affect the firms within them ...
Comparing to  A Firm’s Major Competitors <ul><li>Industry averages may not be representative </li></ul><ul><li>Select a su...
Comparing to  A Firm’s Historical Performance <ul><li>Determine whether it is progressing or declining </li></ul><ul><li>H...
Five Categories of Financial Ratios <ul><li>1. Internal liquidity (solvency) </li></ul><ul><li>2. Operating performance </...
Five Categories of Financial Ratios <ul><li>4. Growth analysis </li></ul>
Five Categories of Financial Ratios <ul><li>5. External liquidity (marketability) </li></ul>
Common Size Statements <ul><li>Normalize balance sheets and income statement items to allow easier comparison of different...
Operating Profitability Ratios <ul><li>Return on owner’s equity (ROE) can be computed for the common- shareholder’s equity...
Operating Profitability Ratios
Operating Profitability Ratios This indicates the pretax return on equity.  To arrive at ROE we must consider the tax rate...
Operating Profitability Ratios
Operating Profitability Ratios <ul><li>In summary, we have the following five components of return on equity (ROE) </li></ul>
Operating Profitability Ratios
Operating Profitability Ratios
Operating Profitability Ratios
Operating Profitability Ratios
Operating Profitability Ratios
The Expanded Du Pont system - Bloomberg and CFA Style: <ul><li>ROE = EBIT/Sales x S/A x EBT/EBIT x A/Eq x EAT/EBT </li></u...
Risk Analysis <ul><li>Total risk of a firm has two components: </li></ul><ul><ul><li>Business risk </li></ul></ul><ul><ul>...
Business Risk <ul><li>Variability of the firm’s operating income over time </li></ul>
Business Risk <ul><li>Variability of the firm’s operating income over time </li></ul><ul><li>Standard deviation of the his...
Business Risk <ul><li>Two factors contribute to the variability of operating earnings </li></ul><ul><ul><li>Sales variabil...
Financial Risk <ul><li>Bonds interest payments come before earnings are available to stockholders </li></ul><ul><li>These ...
Financial Risk <ul><li>Two sets of financial ratios help measure financial risk </li></ul><ul><ul><li>Balance sheet ratios...
Financial Risk <ul><li>Proportion of debt (balance sheet) ratios </li></ul>
Financial Risk <ul><li>Proportion of debt (balance sheet) ratios </li></ul><ul><li>This may be computed with and without d...
Financial Risk <ul><li>Interest Coverage </li></ul>
External Market Liquidity <ul><li>Market Liquidity is the ability to buy or sell an asset quickly with little price change...
External Market Liquidity <ul><li>Determinants of Market Liquidity </li></ul><ul><li>The dollar value of shares traded </l...
External Market Liquidity <ul><li>Trading turnover (percentage of outstanding shares traded during a period of time)  </li...
External Market Liquidity <ul><li>A measure of market liquidity is the bid-ask spread </li></ul>
Analysis of Growth Potential <ul><li>Creditors are interested in the firm’s ability to pay future obligations </li></ul><u...
Determinants of Growth <ul><li>Resources retained and reinvested in the entity </li></ul><ul><li>Rate of return earned on ...
Determinants of Growth <ul><li>ROE is a function of </li></ul><ul><ul><li>Net profit margin </li></ul></ul><ul><ul><li>Tot...
Comparative Analysis of Ratios <ul><li>Internal liquidity </li></ul><ul><ul><li>Current ratio, quick ratio, and cash ratio...
The Quality of Financial Statements <ul><li>Reflect reality rather than use accounting tricks or one-time adjustments to m...
The Quality of Financial Statements <ul><li>High-quality balance sheets typically have  </li></ul><ul><ul><li>Conservative...
The Quality of Financial Statements <ul><li>High-quality income statements reflect repeatable earnings </li></ul><ul><li>G...
 
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Chapter 10

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Chapter 10

  1. 1. Major Financial Statements <ul><li>Corporate shareholder annual and quarterly reports must include </li></ul><ul><ul><li>Balance sheet </li></ul></ul><ul><ul><li>Income statement </li></ul></ul><ul><ul><li>Statement of cash flows </li></ul></ul><ul><li>Reports filed with Securities and Exchange Commission (SEC) </li></ul><ul><ul><li>10-K and 10-Q </li></ul></ul>
  2. 2. Statement of Cash Flows <ul><ul><li>It has three sections: </li></ul></ul><ul><ul><li>Cash Flow from Operating Activities – the sources and uses of cash that arise from the normal operations of a firm </li></ul></ul><ul><ul><li>Cash Flow from Investing activities – change in gross plant and equipment plus the change in the investment account </li></ul></ul><ul><ul><li>Cash Flow from Financing activities – financing sources minus financing uses </li></ul></ul>
  3. 3. Importance of Relative Financial Ratios <ul><li>Compare to other entities </li></ul><ul><li>Examine a firm’s performance relative to: </li></ul><ul><ul><li>The aggregate economy </li></ul></ul><ul><ul><li>Its industry or industries </li></ul></ul><ul><ul><li>Its major competitors within the industry </li></ul></ul><ul><ul><li>Its past performance (time-series analysis) </li></ul></ul>
  4. 4. Comparing to A Firm’s Industry <ul><li>Most popular comparison </li></ul><ul><li>Industries affect the firms within them differently, but the relationship is always significant </li></ul><ul><li>The industry effect is strongest for industries with homogenous products </li></ul><ul><li>Examine the industry’s performance relative to aggregate economic activity </li></ul>
  5. 5. Comparing to A Firm’s Major Competitors <ul><li>Industry averages may not be representative </li></ul><ul><li>Select a subset of competitors to compare to using cross-sectional analysis, or </li></ul><ul><li>Construct a composite industry average from industries the firm operates in </li></ul>
  6. 6. Comparing to A Firm’s Historical Performance <ul><li>Determine whether it is progressing or declining </li></ul><ul><li>Helpful for estimating future performance </li></ul><ul><li>Consider trends as well as averages over time </li></ul>
  7. 7. Five Categories of Financial Ratios <ul><li>1. Internal liquidity (solvency) </li></ul><ul><li>2. Operating performance </li></ul><ul><ul><li>a. Operating efficiency </li></ul></ul><ul><ul><li>b. Operating profitability </li></ul></ul><ul><li>3. Risk analysis </li></ul><ul><ul><li>a. Business risk </li></ul></ul><ul><ul><li>b. Financial risk </li></ul></ul>
  8. 8. Five Categories of Financial Ratios <ul><li>4. Growth analysis </li></ul>
  9. 9. Five Categories of Financial Ratios <ul><li>5. External liquidity (marketability) </li></ul>
  10. 10. Common Size Statements <ul><li>Normalize balance sheets and income statement items to allow easier comparison of different size firms </li></ul><ul><li>A common size balance sheet expresses accounts as a percentage of total assets </li></ul><ul><li>A common size income statement expresses all items as a percentage of sales </li></ul>
  11. 11. Operating Profitability Ratios <ul><li>Return on owner’s equity (ROE) can be computed for the common- shareholder’s equity </li></ul>
  12. 12. Operating Profitability Ratios
  13. 13. Operating Profitability Ratios This indicates the pretax return on equity. To arrive at ROE we must consider the tax rate effect.
  14. 14. Operating Profitability Ratios
  15. 15. Operating Profitability Ratios <ul><li>In summary, we have the following five components of return on equity (ROE) </li></ul>
  16. 16. Operating Profitability Ratios
  17. 17. Operating Profitability Ratios
  18. 18. Operating Profitability Ratios
  19. 19. Operating Profitability Ratios
  20. 20. Operating Profitability Ratios
  21. 21. The Expanded Du Pont system - Bloomberg and CFA Style: <ul><li>ROE = EBIT/Sales x S/A x EBT/EBIT x A/Eq x EAT/EBT </li></ul><ul><li>ROE = O.P.M. x TATO x Interest Burden x EM x Tax Burden </li></ul>It shows how these factors combine to determine the ROE.
  22. 22. Risk Analysis <ul><li>Total risk of a firm has two components: </li></ul><ul><ul><li>Business risk </li></ul></ul><ul><ul><ul><li>The uncertainty of income caused by the firm’s industry </li></ul></ul></ul><ul><ul><ul><li>Generally measured by the variability of the firm’s operating income over time </li></ul></ul></ul><ul><ul><li>Financial risk </li></ul></ul><ul><ul><ul><li>Additional uncertainty of returns to equity holders due to a firm’s use of fixed obligation debt securities </li></ul></ul></ul><ul><ul><ul><li>The acceptable level of financial risk for a firm depends on its business risk </li></ul></ul></ul>
  23. 23. Business Risk <ul><li>Variability of the firm’s operating income over time </li></ul>
  24. 24. Business Risk <ul><li>Variability of the firm’s operating income over time </li></ul><ul><li>Standard deviation of the historical operating earnings series </li></ul>
  25. 25. Business Risk <ul><li>Two factors contribute to the variability of operating earnings </li></ul><ul><ul><li>Sales variability </li></ul></ul><ul><ul><ul><li>Earnings must be as volatile as sales </li></ul></ul></ul><ul><ul><ul><li>Some industries are cyclical </li></ul></ul></ul><ul><ul><li>Operating leverage </li></ul></ul><ul><ul><ul><li>Production has fixed and variable costs </li></ul></ul></ul><ul><ul><ul><li>Fixed production costs cause profit volatility with changes in sales </li></ul></ul></ul><ul><ul><ul><li>Fixed production costs are operating leverage </li></ul></ul></ul>
  26. 26. Financial Risk <ul><li>Bonds interest payments come before earnings are available to stockholders </li></ul><ul><li>These are fixed obligations </li></ul><ul><li>Similar to fixed production costs, these lead to larger earnings during good times, and lower earnings during a business decline </li></ul><ul><li>This debt financing increases the financial risk and possibility of default </li></ul>
  27. 27. Financial Risk <ul><li>Two sets of financial ratios help measure financial risk </li></ul><ul><ul><li>Balance sheet ratios </li></ul></ul><ul><ul><li>Earnings or cash flow available to pay fixed financial charges </li></ul></ul><ul><li>Acceptable levels of financial risk depend on business risk </li></ul>
  28. 28. Financial Risk <ul><li>Proportion of debt (balance sheet) ratios </li></ul>
  29. 29. Financial Risk <ul><li>Proportion of debt (balance sheet) ratios </li></ul><ul><li>This may be computed with and without deferred taxes </li></ul>
  30. 30. Financial Risk <ul><li>Interest Coverage </li></ul>
  31. 31. External Market Liquidity <ul><li>Market Liquidity is the ability to buy or sell an asset quickly with little price change from a prior transaction assuming no new information </li></ul><ul><li>External market liquidity is a source of risk to investors </li></ul>
  32. 32. External Market Liquidity <ul><li>Determinants of Market Liquidity </li></ul><ul><li>The dollar value of shares traded </li></ul><ul><ul><li>This can be estimated from the total market value of outstanding securities </li></ul></ul><ul><ul><li>It will be affected by the number of security owners </li></ul></ul><ul><ul><li>Numerous buyers and sellers provide liquidity </li></ul></ul>
  33. 33. External Market Liquidity <ul><li>Trading turnover (percentage of outstanding shares traded during a period of time) </li></ul>
  34. 34. External Market Liquidity <ul><li>A measure of market liquidity is the bid-ask spread </li></ul>
  35. 35. Analysis of Growth Potential <ul><li>Creditors are interested in the firm’s ability to pay future obligations </li></ul><ul><li>Value of a firm depends on its future growth in earnings and dividends </li></ul>
  36. 36. Determinants of Growth <ul><li>Resources retained and reinvested in the entity </li></ul><ul><li>Rate of return earned on the resources retained </li></ul><ul><ul><li>= RR x ROE </li></ul></ul><ul><ul><li>where: </li></ul></ul><ul><ul><li>g = potential growth rate </li></ul></ul><ul><ul><li>RR = the retention rate of earnings </li></ul></ul><ul><ul><li>ROE = the firm’s return on equity </li></ul></ul>
  37. 37. Determinants of Growth <ul><li>ROE is a function of </li></ul><ul><ul><li>Net profit margin </li></ul></ul><ul><ul><li>Total asset turnover </li></ul></ul><ul><ul><li>Financial leverage (total assets/equity) </li></ul></ul>
  38. 38. Comparative Analysis of Ratios <ul><li>Internal liquidity </li></ul><ul><ul><li>Current ratio, quick ratio, and cash ratio </li></ul></ul><ul><li>Operating performance </li></ul><ul><ul><li>Efficiency ratios and profitability ratios </li></ul></ul><ul><li>Financial risk </li></ul><ul><li>Growth analysis </li></ul>
  39. 39. The Quality of Financial Statements <ul><li>Reflect reality rather than use accounting tricks or one-time adjustments to make things look better than they are </li></ul>
  40. 40. The Quality of Financial Statements <ul><li>High-quality balance sheets typically have </li></ul><ul><ul><li>Conservative use of debt </li></ul></ul><ul><ul><li>Assets with market value greater than book </li></ul></ul><ul><ul><li>No liabilities off the balance sheet </li></ul></ul>
  41. 41. The Quality of Financial Statements <ul><li>High-quality income statements reflect repeatable earnings </li></ul><ul><li>Gains from nonrecurring items should be ignored when examining earnings </li></ul><ul><li>High-quality earnings result from the use of conservative accounting principles that do not overstate revenues or understate costs </li></ul>

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