Chapter 3

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Chapter 3

  1. 1. Chapter 3 Evaluation of Financial Performance
  2. 2. Introduction <ul><li>This chapter introduces financial statement analysis techniques that are used to accurately evaluate a company’s performance. We will assume that the financial statements are fairly and accurately presented. </li></ul>
  3. 3. Financial Ratios Are Used By <ul><li>Management for planning and evaluating </li></ul><ul><li>Credit managers and bankers to estimate the riskiness of potential borrowers </li></ul><ul><li>Investors to evaluate corporate securities </li></ul><ul><li>Managers to identify and assess potential merger candidates </li></ul><ul><li>Widely used and accepted technique </li></ul><ul><ul><li>Use started in the 1920s </li></ul></ul>
  4. 4. Ratio Analysis <ul><li>Many, many ratios </li></ul><ul><ul><li>Choose the ones that are most relevant for you </li></ul></ul><ul><li>Must be compared with a standard and also the past (three years, for example) </li></ul><ul><li>A financial ratio is only an indicator </li></ul><ul><ul><li>One can possibly manipulate ratios </li></ul></ul><ul><li>Accounting differences in firms </li></ul><ul><ul><li>WorldCom (MCI), ENRON, HealthSouth, Ahold, Tyco, etc. </li></ul></ul>
  5. 5. Ratio Classifications <ul><li>Liquidity </li></ul><ul><li>Asset management </li></ul><ul><li>Financial leverage management </li></ul><ul><li>Profitability </li></ul><ul><li>Market-based </li></ul><ul><li>Dividend policy </li></ul>
  6. 6. Major Financial Statements <ul><li>Balance sheet </li></ul><ul><ul><li>Common-sized balance sheet shows assets, liabilities, and equity as a % of total assets </li></ul></ul><ul><li>Income statement </li></ul><ul><ul><li>Common-sized income statement shows income and expense items as a % of net sales </li></ul></ul><ul><li>Statement of cash flows </li></ul>
  7. 7. Common-Sized Statements <ul><li>Publicly-owned firms must publish financial statements quarterly and annually </li></ul><ul><li>Widely used in banking and investments </li></ul>
  8. 8. Liquidity Ratios <ul><li>Current ratio = Current assets </li></ul><ul><li>Current liabilities </li></ul><ul><li>Quick ratio = Current assets - Inventories </li></ul><ul><li>Current liabilities </li></ul><ul><li>Aging Schedule for Accounts Receivable </li></ul>
  9. 9. Asset Management Ratios <ul><li>Average collection period = Accounts receivable </li></ul><ul><li> Annual credit sales/ 365 </li></ul><ul><li>Inventory turnover = Cost of sales </li></ul><ul><li>Average inventory </li></ul><ul><li>Fixed-asset turnover = Sales </li></ul><ul><li>Net fixed assets </li></ul><ul><li>Total asset turnover = Sales </li></ul><ul><li>Total assets </li></ul>
  10. 10. Financial Leverage Management <ul><li>Debt ratio = Total debt </li></ul><ul><li>Total assets </li></ul><ul><li>Debt-to-equity ratio = Total debt </li></ul><ul><li>Total equity </li></ul><ul><li>Times interest earned = EBIT </li></ul><ul><li>Interest charges </li></ul><ul><li>Fixed charge coverage = EBIT + Lease payments </li></ul><ul><li>Interest + Lease payment + P/S div before tax+ Before-tax sinking fund </li></ul>
  11. 11. Profitability Ratios <ul><li>Gross profit margin = Sales - Cost of sales </li></ul><ul><li>Sales </li></ul><ul><li>Net profit margin = EAT </li></ul><ul><li>Sales </li></ul><ul><li>ROI = EAT </li></ul><ul><li>Total Assets </li></ul><ul><li>ROE = EAT </li></ul><ul><li>Stockholders equity </li></ul>
  12. 12. Market-Based Ratios <ul><li>P/E ratio = Market price per share </li></ul><ul><li>Current earnings per share </li></ul><ul><li>Market to book ratio = Market price per share </li></ul><ul><li>Book value per share </li></ul><ul><li>Stock Price/ Free Cash Flow </li></ul>
  13. 13. Dividend Policy Ratios <ul><li>Payout ratio = Dividends per share </li></ul><ul><li>Earnings per share </li></ul><ul><li>Dividend yield = Expected dividends per share </li></ul><ul><li> Stock price </li></ul>
  14. 14. Relationships Among Ratios <ul><li>ROI = EAT x Sales = EAT </li></ul><ul><li>Sales Total assets Total assets </li></ul><ul><li>ROE = EAT x Sales x Total assets </li></ul><ul><li>Sales Total assets Equity </li></ul><ul><li>ROE = Net Profit Margin x Total Asset Turnover x Equity Multiplier </li></ul>DuPont Analysis
  15. 15. Dupont Analysis <ul><li>Widely used in industry </li></ul><ul><li>Shows impacts that operating changes can have on returns </li></ul>
  16. 16. Financial Ratio Analysis <ul><li>Trend analysis 2002 2003 2004 </li></ul><ul><li>XYZ current ratio 1.9 2.2 2.3 </li></ul><ul><li>Cross-sectional analysis 2004 </li></ul><ul><li>XYZ current ratio 2.3 </li></ul><ul><li>Industry norms 2.5 </li></ul><ul><li>Both simultaneously 2002 2003 2004 </li></ul><ul><li>XYZ current ratio 1.9 2.2 2.3 </li></ul><ul><li>Industry norms 2.5 2.4 2.5 </li></ul>
  17. 17. Some Sources of Information <ul><li>Trading Room (406 Sirrine Hall) </li></ul><ul><ul><li>Bridge (Telerate) </li></ul></ul><ul><ul><li>Bloomberg </li></ul></ul><ul><ul><li>Reuters </li></ul></ul><ul><li>General Business File of Cooper Library </li></ul><ul><li>Factiva </li></ul><ul><li>Mergent Database </li></ul><ul><li>TableBase </li></ul><ul><li>Reuters Business Insight </li></ul><ul><li>RMA Annual Statement Studies </li></ul><ul><ul><li>Reserves on 2 nd Floor </li></ul></ul><ul><li>Visit Index Table 3 in Library </li></ul><ul><li>Annual reports </li></ul><ul><li>10K’s - SEC EDGAR Corporate Database </li></ul><ul><li>Standard and Poor’s </li></ul><ul><li>Value Line </li></ul><ul><li>Industry Norms and Key Business Ratios </li></ul><ul><li>The Internet </li></ul>
  18. 18. A Few of the Sources of Information on the Web <ul><li>http://www.bloomberg.com/ </li></ul><ul><li>http://www.sec.gov/ </li></ul><ul><li>http://finance.yahoo.com/ </li></ul><ul><li>http://www.dnbcorp.com/ </li></ul><ul><li>http://www.rmahq.org/ </li></ul><ul><li>http://www.moodys.com/ </li></ul><ul><li>http://www.hoovers.com/ </li></ul><ul><li>But, please be careful. Remember you get what you pay for… </li></ul>
  19. 19. <ul><li>Quality of a firm’s earnings is positively related to the proportion of cash earnings to total earnings and to the proportion of recurring income to total income. </li></ul><ul><li>Large non-cash component in the earnings Significant non-recurring transactions in the income figure </li></ul><ul><li>Quality of a firm’s balance sheet is positively related to the ratio of the market value of the firm’s assets to book value of assets and inversely related to the amount of its hidden liabilities. </li></ul><ul><li>Presence of obsolete inventories and charging off assets </li></ul><ul><li>Hidden assets </li></ul><ul><li>Assets have market values significantly below book values </li></ul>
  20. 20. Problems in Reporting <ul><li>Time of revenue recognition </li></ul><ul><li>Pension Fund Earnings Assumptions </li></ul><ul><li>Amortization of intangible assets </li></ul><ul><li>Including all losses and debt </li></ul><ul><ul><li>Off-Balance-Sheet Financing - ENRON </li></ul></ul>
  21. 21. Ratios Can Be Misleading <ul><li>Differing accounting practices </li></ul><ul><li>Might be significant dispersion in the ratio for the industry </li></ul><ul><li>Many firms operate in more than one industry - Industry classification </li></ul><ul><li>Financial ratios provide a historical record of performance </li></ul>
  22. 22. The Bridge System <ul><li>Turn on Monitor </li></ul><ul><li>Log on </li></ul><ul><li>Click on Telerate </li></ul><ul><li>Double Click on the background </li></ul><ul><li>Go to Analytics Page </li></ul><ul><li>Type: /LU/Company for Ticker Symbol </li></ul><ul><li>Type: the Ticker Symbol/CF </li></ul><ul><ul><li>CF = Corporate Fundamentals </li></ul></ul><ul><li>Scroll through the Corporate Fundamentals </li></ul><ul><li>Type: the Ticker Symbol[Beta </li></ul>
  23. 23. To Obtain the Latest Corporate News <ul><li>Tab to another page in Telerate </li></ul><ul><li>Double click on the background </li></ul><ul><li>Go to News Watch </li></ul><ul><li>Right Click then Search by Ticker Symbol </li></ul><ul><li>Type in the Ticker Symbol </li></ul><ul><li>Then double click on any headline story to bring up the entire story. </li></ul><ul><ul><li>You can print out the story or possibly save it to a disk. </li></ul></ul>
  24. 24. Analysis Based on the Market Value of the Firm <ul><li>Market value added ( MVA ) = Total Market value – Total Capital </li></ul><ul><li>MVA is the market value of debt, preferred stock, and common equity less the Capital raised by investors or Retained Earnings. </li></ul><ul><li>The capital market’s assessment of the accumulated NPV of all of the firm’s past and present projected investment projects. </li></ul>
  25. 25. Economic Value Added (EVA) <ul><li>Economic value added ( EVA ) = [ Return on total capital (r) – Cost of Capital (k )] x Capital </li></ul><ul><li>EVA = EBIT(1 – Corporate tax rate) – (Operating Capital)(k) </li></ul><ul><li>r = net operating profits after taxes divided by beginning of year capital (Return on Capital) </li></ul><ul><li>k = Weighted After-Tax Cost of Capital </li></ul>
  26. 26. EVA - Continued <ul><li>The yearly contribution of a firm’s operations to the creation of MVA. </li></ul><ul><li>EVA measures the extent to which the firm has increased shareholder value in a given year. </li></ul><ul><li>EVA represents the residual value that remains after the cost of all capital, including equity capital has been deducted. </li></ul>
  27. 27. Increase Economic Value Added (EVA) <ul><li>Increase operating efficiency </li></ul><ul><li>Commit new resources that promise a high return </li></ul><ul><li>Redirect resources to more productive uses </li></ul><ul><li>Make prudent use of tax benefits of debt financing </li></ul>
  28. 28. Problems Caused by Inflation <ul><li>Inventory profit as a result of timing of price increases </li></ul><ul><li>Inventory valuation methods </li></ul><ul><li>( LIFO ) ( FIFO ) </li></ul><ul><li>Rising interest rates causes a decline in the value of long term debt </li></ul><ul><li>Differences in the reporting of earnings </li></ul><ul><li>Understatement of fixed assets </li></ul><ul><li>Recognition of sales </li></ul>
  29. 29. The Cash Flow Concept <ul><li>Accounting income Vs Cash flow </li></ul><ul><li>Cash flow is the relevant source of value for the firm </li></ul><ul><li>ATCF = EAT + Noncash charges </li></ul><ul><li>ATCF = EAT + Depreciation + Deferred taxes </li></ul><ul><li>Free Cash Flow (FCF) = EBIT(1 – T) – Net Investment in operating capital </li></ul><ul><li>FCF = (EBIT(1 – T) + Depreciation) – Gross investment in operating capital </li></ul>
  30. 30. Statement of Cash Flows <ul><li>Presents the net cash provided by operating, investing, or financing activities </li></ul><ul><ul><li>Direct method presents the net cash provided by operating, investing, or financing activities </li></ul></ul><ul><ul><li>Indirect method presents the adjustments to net income to show net cash provided </li></ul></ul><ul><ul><li>Used for public financial reports </li></ul></ul><ul><li>The final results are identical </li></ul>
  31. 31. Complex International Aspects of Financial Statement Analysis <ul><li>Influenced by fluctuating exchange rates </li></ul><ul><li>SFAS No. 52 deals with foreign currency translation </li></ul>
  32. 32. Accuracy of Financial Statements <ul><li>External auditor </li></ul><ul><li>Generally accepted accounting principles </li></ul><ul><li>People pose for a picture like a corporation poses for a financial statement </li></ul><ul><li>Sarbanes-Oxley Act of 2002 </li></ul>
  33. 33. Conclusion <ul><li>Financial Statements </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><ul><li>Common-sized </li></ul></ul><ul><ul><li>Sarbanes-Oxley Act </li></ul></ul><ul><li>Ratios </li></ul><ul><ul><li>Liquidity </li></ul></ul><ul><ul><li>Asset management </li></ul></ul><ul><ul><li>Financial leverage </li></ul></ul><ul><ul><li>Profitability </li></ul></ul><ul><ul><li>Market-based </li></ul></ul><ul><ul><li>Dividend policy </li></ul></ul><ul><li>DuPont Analysis </li></ul><ul><li>Sources of information </li></ul><ul><li>Market Value Added </li></ul><ul><li>Economic Value Added </li></ul>

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