Chapter 10 Notes

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Chapter 10 Notes

  1. 1. Chapter 10 Analysis of Financial Statements
  2. 2. Financial Statements <ul><li>Corporate shareholder annual and quarterly reports must include </li></ul><ul><ul><li>Balance sheet (Exhibit 10.1) </li></ul></ul><ul><ul><li>Income statement (Exhibit 10.2) </li></ul></ul><ul><ul><li>Statement of cash flows (Exhibit 10.3) </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><ul><li>All reports must be prepared using GAAP </li></ul>
  3. 3. Common Size Statements <ul><li>Normalize balance sheets and income statement items to allow easier comparison of different size firms </li></ul><ul><li>Common size balance sheet: all accounts are expressed as a percentage of total assets </li></ul><ul><li>Common size income statement: all accounts are expressed as a percentage of sales </li></ul>
  4. 4. Analysis of Financial Ratios <ul><li>Ratios are more informative than raw numbers </li></ul><ul><li>Ratios provide meaningful relationships between individual values in the financial statements </li></ul><ul><li>Ratios help investors evaluate management performance in terms of profitability, efficiency and risk. </li></ul>
  5. 5. Importance of Relative Financial Ratios <ul><li>Enable comparison of a firm’s performance 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>
  6. 6. Five Categories of Financial Ratios <ul><li>1. Internal liquidity (solvency) </li></ul><ul><li>2. Operating efficiency and profitability </li></ul><ul><li>3. Business and financial risk analysis </li></ul><ul><li>4. Growth analysis </li></ul><ul><li>5. External liquidity (marketability) </li></ul>
  7. 7. Internal Liquidity <ul><li>Internal liquidity (solvency) ratios indicate the ability to meet future short-term financial obligations </li></ul><ul><ul><li>Current Ratio </li></ul></ul><ul><ul><li>Quick Ratio </li></ul></ul><ul><ul><li>Cash Ratio </li></ul></ul><ul><ul><li>Inventory Turnover </li></ul></ul><ul><li>All internal liquidity ratios should be compared with industry numbers </li></ul>
  8. 8. Current Ratio (CR) <ul><li>Examines current assets and current liabilities </li></ul><ul><li>A current ratio above 1 is usually best, but a high current ratio isn’t optimal </li></ul>
  9. 9. Quick Ratio (QR) <ul><li>Adjusts current assets by removing less liquid assets </li></ul><ul><li>QR is less or equal to CR </li></ul><ul><li>If QR is much lower than CR, it could signal an inventory problem </li></ul>
  10. 10. Cash Ratio <ul><li>The most conservative liquidity ratio </li></ul><ul><li>A cash ratio of 1 suggests that the firm has enough on hand to meet all current obligations in the coming year </li></ul><ul><li>Usually less than 1 </li></ul>
  11. 11. Inventory Turnover (ITO) <ul><li>Measures efficiency in inventory management </li></ul><ul><li>Usually higher is better </li></ul><ul><li>Time series comparisons also work well for ITO </li></ul>
  12. 12. Average Collection Period (ACP) <ul><li>Compare to credit terms offered </li></ul><ul><li>Varies dramatically depending on product and industry </li></ul><ul><li>Should be close to the norm for the industry </li></ul>
  13. 13. Operating Performance <ul><li>Measure how well management is operating the business </li></ul><ul><ul><li>(1) Operating efficiency ratios </li></ul></ul><ul><ul><ul><li>Examine how the management uses its assets and capital, measured in terms of sales dollars generated by asset or capital categories (total asset turnover and fixed asset turnover) </li></ul></ul></ul><ul><ul><li>(2) Operating profitability ratios </li></ul></ul><ul><ul><ul><li>Analyze profits as a percentage of sales and as a percentage of the assets and capital employed (profit margins and returns on capital) </li></ul></ul></ul>
  14. 14. Total Asset Turnover (TAT) <ul><li>Meaures the effectiveness of a firm’s use of its total asset base </li></ul><ul><li>Higher is better </li></ul><ul><li>May be distorted by inflation </li></ul>
  15. 15. Fixed Asset Turnover (FAT) <ul><li>Measures efficiency of plant and equipment use </li></ul><ul><li>Higher is better </li></ul><ul><li>May be distorted by inflation </li></ul>
  16. 16. Profit Margins <ul><li>Higher is better for all profit margins </li></ul><ul><li>Can be computed on a gross, operating, or net basis </li></ul><ul><ul><li>Gross profit equals sales minus the cost of goods sold </li></ul></ul><ul><ul><li>Operating profit is gross profit minus selling, general and administrative (SG + A) expenses </li></ul></ul><ul><ul><li>Net profit is what is left after all expenses are covered </li></ul></ul>
  17. 17. Return on Equity (ROE) <ul><li>Meaures the rate of return earned on the capital provided by the stockholders after paying for all other capital used </li></ul><ul><li>Higher is better </li></ul>
  18. 18. ROE Decomposition
  19. 19. Return on Assets (ROA) <ul><li>Meaures the rate of return earned on the firm’s assets </li></ul><ul><li>Higher is better </li></ul>
  20. 20. 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 or the s tandard deviation of the historical operating earnings series </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>
  21. 21. 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 are generally 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>
  22. 22. Debt Ratios <ul><li>Higher ratios suggest increased financial risk </li></ul>
  23. 23. Earnings Ratios <ul><li>Higher ratios suggest lower risk </li></ul><ul><li>The Fixed Charge Coverage takes into account non-interest fixed obligations </li></ul>
  24. 24. Cash Flow Ratios <ul><li>Cash flow ratios relate the flow of cash available from operations to either interest expenseor the face value of outstanding debt </li></ul><ul><li>Higher suggests lower risk </li></ul><ul><li>1/3 of a lease payment is used as a measure of interest expense on a lease </li></ul>
  25. 25. Cash Flow Ratios
  26. 26. 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><ul><li>We will discuss these computations in Chapters 11 and 15. </li></ul>
  27. 27. External Market Liquidity <ul><li>The dollar value of shares traded </li></ul><ul><li>Trading turnover (percentage of outstanding shares traded during a period of time) </li></ul><ul><li>The bid-ask spread is a measure of market liquidity </li></ul>
  28. 28. Financial Statement Quality <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>
  29. 29. Financial Statement Quality <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>
  30. 30. The Value of Financial Statement Analysis <ul><li>Financial statements, by their nature, are backward-looking </li></ul><ul><li>An efficient market will have already incorporated these past results into security prices, so why analyze the statements? </li></ul><ul><li>Analysis provides knowledge of a firm’s operating and financial structure </li></ul><ul><li>This aids in estimating future returns </li></ul>
  31. 31. Uses of Ratio Analysis <ul><li>1. Stock valuation </li></ul><ul><li>2. Identification of corporate variables affecting a stock’s systematic risk (beta) </li></ul><ul><li>3. Assigning credit quality ratings on bonds </li></ul><ul><li>4. Predicting insolvency (bankruptcy) of firms </li></ul><ul><li>5. Management of the firm </li></ul>
  32. 32. Stock Valuation Models <ul><li>Valuation models attempt to derive a value based upon one of several cash flow or relative valuation models </li></ul><ul><li>All valuation models are influenced by: </li></ul><ul><li>Expected growth rate of earnings, cash flows, or dividends </li></ul><ul><li>Required rate of return on the stock </li></ul><ul><li>Financial ratios can help in estimating these critical inputs </li></ul>
  33. 33. Limitations of Financial Ratios <ul><li>Accounting treatments may vary among firms, especially among non-U.S. firms </li></ul><ul><li>Firms may have have divisions operating in different industries making it difficult to derive industry ratios </li></ul><ul><li>Foreign firms may follow different reporting formats and different accounting principles </li></ul>

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