Module 3 Analyzing and Interpreting Financial Statements
Common Questions that F/S Analysis Can Help To Answer
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?
Is a Net Income of $100,000 good?
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 .
This module focuses on the disaggregation of Return Measures into
Level I – RNOA and LEV
Level II – Profit Margins and Turnover
Level III – GPM, OEM, ART, INVT, APT, etc.
As well as Liquidity and Solvency Measures
Return on Assets (ROA):
ROA = Net Income / Average 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
Operating vs. Nonoperating
Operating expenses are the usual and customary costs that a company incurs to support its main business activities
Nonoperating expenses relate to the company’s financing and investing activities
Transitory vs. Core
Transitory items are one-time events (e.g., not likely to recur)
Core items are likely to recur (persist) and are, therefore, more relevant for company valuation
Operating/Nonoperating vs. Core/Transitory
Return on Equity – Level 1
Return on equity (ROE) is computed as:
ROE = Net Income / Average Equity
Return on Net Operating Assets (RNOA) RNOA = NOPAT / Average NOA where, NOPAT is net operating profit after tax NOA is net operating assets
Financial Leverage and Risk
LEV is the other component of ROE
Is Debt a bad thing?
Given that increases in financial leverage increase ROE, why are all companies not 100% debt financed?
Leverage and Income Variability
Level II Analysis – Margin and Turnover
Level 3 Analysis — Disaggregation of Margin and Turnover
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.
Operating Expense Margin
Operating expense ratios (percents) are used to examine the proportion of sales consumed by each major expense category.