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  1. 1. Financial Statement Analysis FIL 341 Prepared by Keldon Bauer
  2. 2. Ratio Analysis <ul><li>Financial ratios are the vital signs of the business. </li></ul><ul><ul><li>They are used to assess the health of the business. </li></ul></ul><ul><ul><li>When they are off the norm, they should be taken together with all known information to get a correct diagnosis. </li></ul></ul><ul><li>Norms should be seen as a normal range, not just one number . </li></ul>
  3. 3. Ratio Analysis <ul><li>Ratios also allow for better comparison through time or between companies. </li></ul><ul><li>As we look at each ratio, ask yourself what the ratio is trying to measure and why is that information important. </li></ul><ul><li>Ratios are used both internally and externally. </li></ul>
  4. 4. Categories of Financial Ratios <ul><li>Short-term solvency or liquidity ratios </li></ul><ul><li>Asset management or efficiency ratios </li></ul><ul><li>Long-term solvency or financial leverage ratios </li></ul><ul><li>Debt coverage ratios </li></ul><ul><li>Profitability ratio </li></ul><ul><li>Market value ratios </li></ul>
  5. 5. Liquidity Ratios <ul><li>Relate short-term sources of and uses for cash. </li></ul><ul><li>Current Ratio: </li></ul>
  6. 6. Liquidity Ratios <ul><li>Quick (Acid Test) Ratio: </li></ul>
  7. 7. Liquidity Ratios <ul><li>Cash ratio : </li></ul>
  8. 8. Asset Management Ratios <ul><li>Purpose is to assess how well the firm is managing assets </li></ul><ul><li>Inventory turnover ratio (IT): </li></ul>
  9. 9. Asset Management Ratios <ul><li>Accounts receivable turnover (ART): </li></ul>
  10. 10. Asset Management Ratios <ul><li>Accounts payable turnover (APT): </li></ul>
  11. 11. Asset Management Ratios <ul><li>Fixed asset turnover (FAT): </li></ul>
  12. 12. Efficiency Ratios <ul><li>Total Asset Turnover (TAT): </li></ul>
  13. 13. Leverage Ratios <ul><li>Relate debt to equity sources of investment funds . </li></ul><ul><li>Debt Ratio: </li></ul>
  14. 14. Leverage Ratios <ul><li>Debt-Equity Ratio: </li></ul><ul><ul><li>Measures the proportion of debt to equity currently used to finance the firm. </li></ul></ul>
  15. 15. Coverage Ratios <ul><li>Measure of ability to meet debt contracts. </li></ul><ul><li>Times Interest Earned (TIE) Ratio: </li></ul><ul><ul><li>Measures how many times the interest expense could be covered by operating earnings. </li></ul></ul>
  16. 16. Coverage Ratios <ul><li>EBITDA Ratio: </li></ul><ul><ul><li>Conservatively estimates how many times the principal and interest payments could be made from operating cash flow. </li></ul></ul>
  17. 17. Profitability Ratios <ul><li>What’s the bottom line? </li></ul><ul><li>Gross Profit Margin (GPM): </li></ul><ul><ul><li>Measures how much profit is gained due to pricing. </li></ul></ul>
  18. 18. Profitability Ratios <ul><li>Operating Profit Margin (OPM): </li></ul><ul><ul><li>Measures how much profit can be pulled through ongoing operations. </li></ul></ul>
  19. 19. Profitability Ratios <ul><li>Net Profit Margin (NPM): </li></ul><ul><ul><li>Measures how much money from every dollar is pulled through as net profit. </li></ul></ul>
  20. 20. Profitability Ratios <ul><li>Basic earning power ratio (BEP): </li></ul>
  21. 21. Profitability Ratios <ul><li>Return on Total Assets (ROA): </li></ul><ul><ul><li>This is a measure of the return on assets owned. </li></ul></ul><ul><ul><li>Therefore, it is a measure of return to all invested funds. </li></ul></ul>
  22. 22. Profitability Ratios <ul><li>Return on Equity (ROE): </li></ul><ul><ul><li>This is a measure of return to the equity holder (whether or not they get a dividend). </li></ul></ul>
  23. 23. Profitability Ratios <ul><li>Return on Common Equity (ROCE): </li></ul><ul><ul><li>This is a measure of return to all equity holders. </li></ul></ul>
  24. 24. Deriving the Du Pont Identity <ul><li>ROE = NI / TE </li></ul><ul><li>Multiply by 1 and then rearrange </li></ul><ul><ul><li>ROE = (NI / TE) (TA / TA) </li></ul></ul><ul><ul><li>ROE = (NI / TA) (TA / TE) = ROA * EM </li></ul></ul><ul><li>Multiply by 1 again and then rearrange </li></ul><ul><ul><li>ROE = (NI / TA) (TA / TE) (Sales / Sales) </li></ul></ul><ul><ul><li>ROE = (NI / Sales) (Sales / TA) (TA / TE) </li></ul></ul><ul><ul><li>ROE = PM * TAT * EM </li></ul></ul>
  25. 25. Predicting Financial Distress <ul><li>Altman’s Z was developed using a Probit model to estimate the probability that a firm would go into bankruptcy. </li></ul><ul><ul><li>His model was not published. </li></ul></ul><ul><li>Since 1968, private firms have duplicated his work to give us a similar model (only published this time). </li></ul>
  26. 26. Predicting Financial Distress <ul><li>There are two models: </li></ul><ul><ul><li>For publicly traded companies: </li></ul></ul><ul><ul><ul><li>Z = 1.2X 1 + 1.4X 2 + 3.3X 3 + 0.6X 4 + X 5 </li></ul></ul></ul><ul><ul><li>For private firms: </li></ul></ul><ul><ul><ul><li>Z = 0.717X 1 +0.847X 2 +3.107X 3 +0.42X 4 +0.998X 5 </li></ul></ul></ul><ul><ul><li>Z is a normally distributed variable, where: </li></ul></ul><ul><ul><ul><li>Z<1.81 Bankruptcy is predicted within a year. </li></ul></ul></ul><ul><ul><ul><li>1.81<Z<2.675 Financial distress, possible bankruptcy </li></ul></ul></ul><ul><ul><ul><li>Z>2.675 No financial distress predicted </li></ul></ul></ul>
  27. 27. Predicting Financial Distress <ul><ul><li>X 1 = Net Working Capital /Total Assets </li></ul></ul><ul><ul><li>X 2 = Retained Earnings/Total Assets </li></ul></ul><ul><ul><li>X 3 = EBIT/Total Assets </li></ul></ul><ul><ul><li>X 4 = Market Value of All Equity/Book Value of Total Liabilities </li></ul></ul><ul><ul><ul><li>In the private firm model Book Value of Equity is substituted for Market Value of Equity </li></ul></ul></ul><ul><ul><li>X 5 = Sales/Total Assets </li></ul></ul><ul><li>What does each variable measure? </li></ul>
  28. 28. Trend Analysis <ul><li>Seeing how ratios change over time. </li></ul><ul><ul><li>Are they getting better or worse over time? </li></ul></ul><ul><li>Helps to determine the direction the firm is heading. </li></ul><ul><li>Show example . </li></ul><ul><li>Can be enhanced by graphing them. </li></ul>
  29. 29. Trend Analysis
  30. 30. Industry Averages <ul><li>To compare the firm’s performance to that of similar firms, many use industry averages: </li></ul><ul><ul><li>Risk Management Association (RMA) </li></ul></ul><ul><ul><ul><li>Focuses on private companies. </li></ul></ul></ul><ul><ul><ul><li>The target audience is commercial lenders. </li></ul></ul></ul><ul><ul><ul><ul><li>The source is also lenders. </li></ul></ul></ul></ul><ul><ul><ul><li>Industries are defined using NAICS system. </li></ul></ul></ul><ul><ul><ul><li>Data are organized by size (assets or sales). </li></ul></ul></ul><ul><ul><ul><li>Most ratios include upper/lower quartiles as well as average. </li></ul></ul></ul>
  31. 31. Industry Averages <ul><ul><li>Dunn and Bradstreets </li></ul></ul><ul><ul><ul><li>Focuses on publicly traded companies. </li></ul></ul></ul><ul><ul><ul><li>Industries are defined using SIC system. </li></ul></ul></ul><ul><ul><ul><ul><li>Also used by SEC. </li></ul></ul></ul></ul><ul><ul><ul><li>Data are clumped together (no size adjustments). </li></ul></ul></ul><ul><ul><ul><li>Most ratios include upper/lower quartiles as well as average. </li></ul></ul></ul><ul><ul><ul><ul><li>But there are not many ratios covered. </li></ul></ul></ul></ul>
  32. 32. Dunn & Bradstreet Common Size Balance Sheet
  33. 33. Dunn & Bradstreet Key Financial Ratios
  34. 34. Excel Language <ul><li>Logical operator IF </li></ul><ul><ul><li>To have Excel automatically test cell addresses, use: </li></ul></ul><ul><ul><ul><li>=IF( Logical test , Value if true , Value if false ) </li></ul></ul></ul><ul><ul><ul><ul><li>The logical test can use =, <, >, <>, <=, or >=. </li></ul></ul></ul></ul><ul><ul><ul><ul><li>E.g. =IF( A5>1 , 6 , 0 ). </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Although the logical test usually uses values, it can use labels. </li></ul></ul></ul></ul><ul><ul><ul><li>Value if true/false can be a value or a label. </li></ul></ul></ul><ul><ul><ul><ul><li>Values are entered directly. </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Labels are entered with quotation marks. </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Blanks are entered as “”. </li></ul></ul></ul></ul>
  35. 35. Excel Language <ul><li>Logical operator IF – continued </li></ul><ul><ul><li>If the test is complex, either AND or OR should be used. </li></ul></ul><ul><ul><li>AND can be used if more than one logical test must be passed for the values to be applied. </li></ul></ul><ul><ul><li>OR can be used if at least one logical test must be passed for the values to be applied. </li></ul></ul><ul><ul><ul><li>E.g. =IF( OR(A5>3, A5<-3) , “Cool” , “Bummer” ) </li></ul></ul></ul>
  36. 36. Excel Language <ul><li>Logical operator IF – continued </li></ul><ul><ul><li>The IF statement can contain another, nested IF statement. </li></ul></ul><ul><ul><ul><li>E.g. =IF( A5>2.65 , “Great” , IF(A5<0.86, “Crap”, “Ok” ) </li></ul></ul></ul><ul><ul><ul><li>If many nested IF statements are contemplated, then you should probably use a lookup table rather than a nested IF statement. </li></ul></ul></ul>
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