Module 7


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Module 7

  1. 1. The Analysis of Financial Statements BA 617 Module 7
  2. 2. Step One <ul><li>Who is the user? </li></ul><ul><li>Different users have different information needs. </li></ul>Establish the objectives of the analysis!
  3. 3. Potential Financial Statement Users: <ul><li>Creditors </li></ul><ul><li>Investors </li></ul><ul><li>Managers </li></ul><ul><li>What types of questions do each of these users seek answers to? </li></ul>
  4. 4. Creditors <ul><li>Why does the firm want/need to borrow funds? </li></ul><ul><li>What is the firm’s capital structure? How leveraged are they? </li></ul><ul><li>How will they pay it back? What kind of cash flows are being generated by operations? </li></ul>
  5. 5. Investors <ul><li>How has the firm performed/what are future expectations? </li></ul><ul><li>How much RISK is inherent in the capital structure? </li></ul><ul><li>What are expected returns from the firm? </li></ul><ul><li>What is firm’s competitive position? </li></ul>
  6. 6. Managers <ul><li>Need all info creditors and investors need PLUS: </li></ul><ul><li>What operating areas have contributed to success and which have not? </li></ul><ul><li>What are strengths/weaknesses of company’s financial position? </li></ul><ul><li>What changes are indicated to improve future performance? </li></ul>
  7. 7. Caution!!! <ul><li>Keep in mind: management PREPARES financial statements </li></ul><ul><li>Analyst should be alert to potential for management to influence reporting to make data more “appealing” </li></ul><ul><li>May want to supplement analysis with information apart from Annual Report prepared by management </li></ul>
  8. 8. Steps 2 and 3 Study the industry Develop knowledge of firm
  9. 9. Where to look for data... <ul><li>Financial statements (and notes) </li></ul><ul><li>Auditor’s report </li></ul><ul><li>MD&A </li></ul><ul><li>Supplementary schedules </li></ul><ul><li>All of the above are in Annual Report -- can also look further... </li></ul>
  10. 10. Other Data Sources <ul><li>10K and 10Q reports filed with SEC </li></ul><ul><li>Computerized data bases </li></ul><ul><ul><li>Info on industry norms/ratios </li></ul></ul><ul><ul><li>Info on particular companies/industries/mutual funds </li></ul></ul><ul><li>Articles in popular/business press </li></ul><ul><li>Ever-expanding websites </li></ul>
  11. 13. ValueLine Username and Password Available to Mercer students only! USERID: 156339 Password: stocks
  12. 14. Great Analysis Tool <ul><li> </li></ul>Try out the benchmarking assistant!
  13. 15. More sources of info <ul><li>SIC Manual </li></ul><ul><li>Industry Averages and Comparison with Competitors </li></ul><ul><ul><li>The Dept of Commerce Financial Report </li></ul></ul><ul><ul><li>Robert Morris Associates Annual Statement Studies </li></ul></ul><ul><ul><li>Standard & Poor’s Industry Surveys </li></ul></ul><ul><ul><li>Almanac of Business and Industrial Financial Ratios </li></ul></ul><ul><ul><li>D&B Industry Norms and Key Business Ratios </li></ul></ul><ul><li>Compact Disclosure </li></ul>
  14. 16. Step 4 Evaluate financial statements
  15. 17. Basic Tools <ul><li>Common size financial statements </li></ul><ul><li>Financial ratios </li></ul><ul><li>Trend analysis </li></ul><ul><li>Structural analysis </li></ul><ul><li>Industry comparisons </li></ul><ul><li>Common sense and judgment (often the hardest to use!) </li></ul>
  16. 18. Common Size Statements <ul><li>Common size income statement </li></ul><ul><ul><li>expresses each income statement category as a percentage of net sales </li></ul></ul><ul><li>Common size balance sheet </li></ul><ul><ul><li>expresses each item on balance sheet as a percentage of total assets or equities </li></ul></ul><ul><li>Both statements facilitate structural analysis of the firm </li></ul>
  17. 19. Financial Ratio Categories <ul><li>Liquidity Ratios </li></ul><ul><ul><li>measure a firm’s ability to meet cash needs as they arise </li></ul></ul><ul><li>Activity Ratios </li></ul><ul><ul><li>measure the liquidity of specific assets and the efficiency of managing assets </li></ul></ul>
  18. 20. Ratio Categories (continued) <ul><li>Leverage Ratios </li></ul><ul><ul><li>measure the extent of a firm’s financing with debt relative to equity and its ability to cover interest and other fixed charges </li></ul></ul><ul><li>Profitability Ratios </li></ul><ul><ul><li>measure the overall performance of a firm and its efficiency in managing assets, liabilities and equity </li></ul></ul>
  19. 21. Caution!!!!!! <ul><li>Ratios are valuable, BUT….. </li></ul><ul><ul><li>They do not provide answers in an of themselves and are not predictive </li></ul></ul><ul><ul><li>They should be used with other elements of financial analysis </li></ul></ul><ul><ul><li>There are no “rules of thumb” that apply to interpretation of ratios </li></ul></ul><ul><li>KEEPING THIS IN MIND, LET’S TAKE A LOOK AT SOME OF THE RATIOS…. </li></ul>
  20. 22. Liquidity Ratios <ul><li>Current Ratio </li></ul><ul><ul><li>Current Assets/Current Liabilities </li></ul></ul><ul><ul><li>Measures ability to meet short-term cash needs </li></ul></ul><ul><li>Quick or Acid Test Ratio </li></ul><ul><ul><li>Current Assets-Inventory/Current Liabilities </li></ul></ul><ul><ul><li>Measure ability to meet short-term cash needs more rigorously </li></ul></ul>
  21. 23. Liquidity Ratios (continued) <ul><li>Cash Flow Liquidity Ratio </li></ul><ul><ul><li>Cash+Marketable Securities+Cash Flow from Operating Activities/Current Liabilities </li></ul></ul><ul><ul><li>Focuses on ability of the firm to generate operating cash flows as a source of liquidity </li></ul></ul>
  22. 24. Activity Ratios <ul><li>Average Collection Period </li></ul><ul><ul><li>Accounts Receivable/Average Daily Sales </li></ul></ul><ul><ul><li>Helps gauge liquidity of accounts receivable (ability to collect cash from customers) </li></ul></ul><ul><li>Accounts Receivable Turnover </li></ul><ul><ul><li>Net Sales/Accounts Receivable </li></ul></ul><ul><ul><li>Another measure of efficiency of firm’s collection and credit policies </li></ul></ul>
  23. 25. Activity Ratios (continued) <ul><li>Inventory Turnover </li></ul><ul><ul><li>Cost of Goods Sold/Inventory </li></ul></ul><ul><ul><li>Measures efficiency of inventory management </li></ul></ul><ul><li>Fixed Asset and Total Asset Turnover </li></ul><ul><ul><li>Net Sales/Net PP&E (Fixed Asset T/O) </li></ul></ul><ul><ul><li>Net Sales/Total Assets (Total Asset T/O) </li></ul></ul><ul><ul><li>Both assess effectiveness in generating sales from investment in assets </li></ul></ul>
  24. 26. Leverage: Debt Ratios <ul><li>Debt Ratio </li></ul><ul><ul><li>Total Liabilities/Total Assets </li></ul></ul><ul><li>Long-Term Debt to Total Capitalization </li></ul><ul><ul><li>Long-term Debt/Long-term Debt + Stockholders’ Equity </li></ul></ul><ul><li>Debt to Equity Ratio </li></ul><ul><ul><li>Total Liabilities/Stockholders’ Equity </li></ul></ul><ul><li>All three measure extent of firm’s financing with debt </li></ul>
  25. 27. Leverage: Coverage Ratios <ul><li>Proportion and amount of debt in capital structure is important to analyst </li></ul><ul><li>Tradeoff between risk and return </li></ul><ul><li>Use of debt involves risk -- commitment to fixed charges </li></ul><ul><li>Fixed charges must be COVERED -- following are some ratios to assess coverage…... </li></ul>
  26. 28. Coverage Ratios (continued) <ul><li>Times Interest Earned </li></ul><ul><ul><li>Operating Profit/Interest Expense </li></ul></ul><ul><ul><li>Indicates how well operating earnings cover fixed interest charges </li></ul></ul><ul><li>Fixed Charge Coverage </li></ul><ul><ul><li>Operating Profit + Lease Payments/Interest Expense + Lease Payments </li></ul></ul><ul><ul><li>Broader measure of how well operating earnings cover fixed charges </li></ul></ul>
  27. 29. Coverage Ratios (continued) <ul><li>Cash Flow Adequacy </li></ul><ul><ul><li>Cash Flow from Operating Activities/ Average Annual Long-Term Debt Maturities </li></ul></ul><ul><ul><li>Measures firm’s ability to cover long-term debt maturities each year </li></ul></ul><ul><ul><li>Rationale is that over the long-run operating cash flows must be adequate to cover investing activities financed with debt </li></ul></ul>
  28. 30. Profitability Ratios <ul><li>Gross Profit Margin </li></ul><ul><ul><li>Gross Profit/Net Sales </li></ul></ul><ul><li>Operating Profit Margin </li></ul><ul><ul><li>Operating Profit/Net Sales </li></ul></ul><ul><li>Net Profit Margin </li></ul><ul><ul><li>Net Earnings/Net Sales </li></ul></ul><ul><li>All measure firm’s ability to translate sales dollars into profits </li></ul>
  29. 31. Profitability Ratios (continued) <ul><li>Cash Flow Margin </li></ul><ul><ul><li>Cash Flow from Operating Activities / Net Sales </li></ul></ul><ul><ul><li>Measures ability to translate sales into cash (with which to pay bills!) </li></ul></ul>
  30. 32. Profitability Ratios (continued) <ul><li>Return on Investment (or Return on Assets -- same thing, different words!) </li></ul><ul><ul><li>Net Earnings/Total Assets </li></ul></ul><ul><li>Return on Equity </li></ul><ul><ul><li>Net Earnings/Stockholders’ Equity </li></ul></ul><ul><li>Both measure overall efficiency of firm in managing investment in assets and generating return to stockholders </li></ul>
  31. 33. Profitability Ratios (continued) <ul><li>Cash Return on Assets </li></ul><ul><ul><li>Cash Flow from Operating Activities / Total Assets </li></ul></ul><ul><ul><li>Useful comparison to return on investment </li></ul></ul><ul><ul><li>Indicates firm’s ability to generate cash from utilizing its assets </li></ul></ul>
  32. 34. Other Ratios You Hear About.. <ul><li>Earnings per Common Share </li></ul><ul><ul><li>Net Earnings/Average Common Shares Outstanding </li></ul></ul><ul><ul><li>Indicates return on a per share basis </li></ul></ul><ul><li>Price to Earnings </li></ul><ul><ul><li>Market Price of Common Stock/Earnings per Common Share </li></ul></ul><ul><ul><li>Expresses a multiple the stock market places on earnings </li></ul></ul>
  33. 35. Other Ratios (continued) <ul><li>Dividend Payout </li></ul><ul><ul><li>Dividends per Share/Earnings per Share </li></ul></ul><ul><ul><li>Shows percentage of earnings paid out to stockholders </li></ul></ul><ul><li>Dividend Yield </li></ul><ul><ul><li>Dividends per Share/Market Price of Common Share </li></ul></ul><ul><ul><li>Shows rate earned by shareholders from dividends relative to current stock price </li></ul></ul>
  34. 36. Analyzing the Company <ul><li>Now that some of the “tools” of financial analysis have been illustrated, where does one go from here? </li></ul>
  35. 37. Step 5 Summarize Findings
  36. 38. Red Flags <ul><li>Changes in top company management </li></ul><ul><li>Key financial ratios indicating deteriorating trends and/or weaknesses relative to industry competitors </li></ul><ul><li>Cash flow from operations declining, negative, volatile, or not tracking with net income. </li></ul><ul><li>Lack of profitability in key operating areas. </li></ul>
  37. 39. More Red Flags <ul><li>Price to earnings ratio low relative to competitors </li></ul><ul><li>Firm’s earnings less than after-tax cost of debt </li></ul><ul><li>Declining operating profits when debt is rising </li></ul><ul><li>Deteriorating trends in operating segments </li></ul>
  38. 40. Accomplishments <ul><li>Reviewed all the basic financial statements and know what they are </li></ul><ul><li>Practiced the rudiments of financial analysis </li></ul><ul><li>If nothing else, hopefully gained an appreciation of what information is available and how one might use it... </li></ul>
  39. 41. A Final Note <ul><li>Financial analysis is only as good as the information upon which it is based -- hence we need to be concerned about honest, straightforward, comprehensible financial reporting </li></ul><ul><li>Financial analysis is only valuable to me if it answers MY questions -- I need to THINK about what I need/would like to know BEFORE I crunch numbers </li></ul>
  40. 42. A Final Final Note (really!) <ul><li>Analyzing financial information can be fun (as well as profitable) </li></ul><ul><li>You can never know too much about a company you plan to have a relationship with (as an investor, a creditor, a manager, an employee) </li></ul>
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