Decoding Financial
Statements
Strictly Financials
Saturday
January 4, 2014
Donald W. Reynolds National Center
For Business Journalism
At Arizona State University

Strictly Financials

2
n 

Gary Trennepohl, Ph.D.
n 
n 
n 
n 

n 

ONEOK Chair and President’s Council Professor of Finance
Oklahoma State ...
Topics
n 

Saturday:
n 

n 

n 

8:30 am to 3:00 pm – Decoding Financial
Statements and Company Analysis.
3:15 pm to 5...
When Studying Finance,
Sometimes it may feel like this:

Strictly Financials

5
USING FINANCIAL RATIOS TO
ANALYZE A COMPANY

Strictly Financials

6
Part 1: Decoding Financial Statements

1. Financial Ratios – what they tell us
2. Profitability Model – how the firm gener...
1. Ratios
A. To Measure Financial Health
n 

Liquidity
current ratio

=

Current assets
Current liabilities

quick ratio
...
Another View of Liquidity:
Net Working Capital
Total Assets

= Liab.+Net Worth
Current liabilities

Current Assets

Net Wo...
B. Ratios to Measure Profits
net profit margin =

net profit after tax
sales

return on assets =

net profit after tax
tot...
Factors Affecting Profitability:
cost of goods sold

inventory turnover =

inventory

accounts receivable
collection perio...
C. Debt Ratios
n 

How is the firm financed?
debt ratio
=
debt/equity ratio

equity multiplier

=

=

Strictly Financials...
D. Equity Return Ratios
n 

What return is generated for common
stockholders?
return on equity

=

Strictly Financials

E...
2. Profitability Model – How a Firm
Generates Profits
n 

The profitability model is useful because it
separates return o...
The Profitability Model is a Function
of Three Ratios
n 

Return on equity is equal to :
NPM X total asset turnover X equ...
INVESTING IN A TIME OF
UNCERTAINTY

Strictly Financials

16
Understanding How Markets Work
Who are the Market Participants
Things in Percentages
Learning from the past: A History of
...
Four Categories of Market
Participants
n 

Investors
n 
n 

n 
n 
n 

Institutional
Retail

Speculators
Market Maker...
Things in Percentages:
Returns and Basis Points
n 

Stocks:
n 

n 

Bonds:
n 

n 

Returns include dividends and capi...
C. Perspectives Over Three
Generations
n 
n 
n 

n 

n 
n 
n 

1930’s: A worldwide Depression
1940’s: A world war t...
Demographics Driving Economics
from 1950 to 2012
n 

n 

n 

U.S. stocks enjoyed a boom in the 1980’s and the
returns i...
What this Means for Investors
n 

Put your fears into perspective:
n 

n 

n 

Take selective risks:
n 
n 

n 

War...
History of U.S. Stock and Bond
Returns Provides a Perspective for
the Future

Strictly Financials

23
Strictly Financials

24
Strictly Financials

25
Bonds as an Investment

Strictly Financials

26
Strictly Financials

27
Long Term U.S. Treasury Rates and Inflation
16%

16%

14%

14%

12%

12%

10%

10%
Bond Yield

8%

8%

6%

6%

4%

4%

2%
...
“The Bond Buyer’s Dilemma”
By Burton Malkiel in the WSJ, Dec 7, 2011
n 

n 

The yields on long term U.S. Treasuries wil...
Strictly Financials

30
THE VIX – A MEASURE OF EXPECTED
MARKET VOLATILITY (RISK).

Strictly Financials

31
You Can Keep Track of Current
Market Volatility with the VIX
n 

n 

n 

The “VIX” is a measure of the market’s percept...
Historic Volatility Since 1898
30-Day Historic Volatility for U.S. Stock Indexes -(DJIA 1898 - 1956, and S&P 500 for 1957 ...
Stock and Bond Returns If
Markets are “Efficient” ….
Market efficiency refers to how quickly
security prices reflect new i...
Implications of Market Efficiency for
Investors
n 

n 
n 

n 

Stock experts don’t have an advantage over
amateurs bec...
Implications (con’t)
n 

n 

n 
n 

Fundamental analysis and brokerage firm
recommendations will not enable you to ide...
How Then Should We Invest as
Retail Investors?
1. 

Buy and hold a well-diversified portfolio through time
– and make sure...
So, What Does All
Of This Data Tell Us?
n 

n 

n 

n 

First, remember when people say “this time is
different,” it i...
Diversification in an Institutional
Investor Portfolio
1) 

2) 

3) 
4) 
5) 
6) 
7) 
8) 

Stocks - Large cap, small cap, g...
How Demographics Will Drive
International Investing Activity

Strictly Financials

40
The Changing Demographics of
Major Countries
1. 

2. 

Countries with larger numbers of younger
workers will enjoy higher ...
United States

42
Italy

43
Germany

44
China

45
Brazil

46
India

47
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Strictly Financials 2014: Decoding Financial Statements by Gary Trennepohl

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Garry Trennepohl presents "Decoding Financial Statements" during the Reynolds Center for Business Journalism's annual Business Journalism Week, Jan. 4, 2014. Trennepohl is the ONEOK Chair of Finance at Oklahoma State University.

The annual event features two concurrent seminars, Business Journalism Professors and Strictly Financials for journalists.

For more information about business journalism training, please visit http://businessjournalism.org.

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Strictly Financials 2014: Decoding Financial Statements by Gary Trennepohl

  1. 1. Decoding Financial Statements Strictly Financials Saturday January 4, 2014
  2. 2. Donald W. Reynolds National Center For Business Journalism At Arizona State University Strictly Financials 2
  3. 3. n  Gary Trennepohl, Ph.D. n  n  n  n  n  ONEOK Chair and President’s Council Professor of Finance Oklahoma State University Trustee, Oklahoma Teachers Retirement System Member, OSU Foundation Investment Committee gary.trennepohl@okstate.edu Strictly Financials 3
  4. 4. Topics n  Saturday: n  n  n  8:30 am to 3:00 pm – Decoding Financial Statements and Company Analysis. 3:15 pm to 5:00 pm – Investing in a Time of Uncertainty Sunday: n  8:30 am to 11:15 am – Fellows Reports on Story Projects Strictly Financials 4
  5. 5. When Studying Finance, Sometimes it may feel like this: Strictly Financials 5
  6. 6. USING FINANCIAL RATIOS TO ANALYZE A COMPANY Strictly Financials 6
  7. 7. Part 1: Decoding Financial Statements 1. Financial Ratios – what they tell us 2. Profitability Model – how the firm generates profits Strictly Financials 7
  8. 8. 1. Ratios A. To Measure Financial Health n  Liquidity current ratio = Current assets Current liabilities quick ratio = Current assets - inventory Current liabilities Strictly Financials 8
  9. 9. Another View of Liquidity: Net Working Capital Total Assets = Liab.+Net Worth Current liabilities Current Assets Net Working Capital Long Term Debt + Fixed Assets Common equity Strictly Financials 9
  10. 10. B. Ratios to Measure Profits net profit margin = net profit after tax sales return on assets = net profit after tax total assets total asset turnover = Strictly Financials sales total assets 10
  11. 11. Factors Affecting Profitability: cost of goods sold inventory turnover = inventory accounts receivable collection period accounts receivable = Strictly Financials (sales/365 days) 11
  12. 12. C. Debt Ratios n  How is the firm financed? debt ratio = debt/equity ratio equity multiplier = = Strictly Financials total debt total assets total debt total equity total assets common equity 12
  13. 13. D. Equity Return Ratios n  What return is generated for common stockholders? return on equity = Strictly Financials EACS common equity 13
  14. 14. 2. Profitability Model – How a Firm Generates Profits n  The profitability model is useful because it separates return on equity (ROE) into three components n  n  n  n  financial leverage (equity multiplier), operating efficiency (net profit margin) asset utilization (total asset turnover). ROE is a function of all three factors Strictly Financials 14
  15. 15. The Profitability Model is a Function of Three Ratios n  Return on equity is equal to : NPM X total asset turnover X equity multiplier ROE = net profit sales X sales total assets Strictly Financials X total assets common equity 15
  16. 16. INVESTING IN A TIME OF UNCERTAINTY Strictly Financials 16
  17. 17. Understanding How Markets Work Who are the Market Participants Things in Percentages Learning from the past: A History of Return and Risk in the Markets. Concept of Market Efficiency Changing Demographics will drive Investment and Returns in the Future
  18. 18. Four Categories of Market Participants n  Investors n  n  n  n  n  Institutional Retail Speculators Market Makers Brokers Strictly Financials 18
  19. 19. Things in Percentages: Returns and Basis Points n  Stocks: n  n  Bonds: n  n  Returns include dividends and capital appreciation Returns include interest payments and bond price changes (a function of interest rates) A basis point (aka as “bips” for bps) n  n  .0001 equals .01% or ONE basis point. So, 1% equals 100 bps. Interest rate changes and Investment Management fees often are stated in basis points. Strictly Financials 19
  20. 20. C. Perspectives Over Three Generations n  n  n  n  n  n  n  1930’s: A worldwide Depression 1940’s: A world war that cost 50 million lives 1950’s: The Korean Conflict; A Cold War and threatened worldwide nuclear destruction. 1960-1980’s: Vietnam: Arab Oil Embargo in 1974, severe inflation, wage and price controls, another oil shock, the dissolution of the Soviet Union. 1990’s: The Tech Revolution and the Internet 2000’s: Two wars in the Middle East and 9/11/2001. Last 10 years: a real estate bubble; toxic mortgage securities; “The Great Recession” and near collapse of the world banking system. 20
  21. 21. Demographics Driving Economics from 1950 to 2012 n  n  n  U.S. stocks enjoyed a boom in the 1980’s and the returns in the’90’s averaged 18% yearly. 2000’s decade returns: S&P returned 1%, Bonds 6% annually. Nov. 2003 to Nov. 2013 n  n  n  n  S&P 500 = 7.69% MSCI World = 7.4% U.S. Long term Treasury Bonds = 6.27% How has investor perspectives about stocks changed since 1950? 21
  22. 22. What this Means for Investors n  Put your fears into perspective: n  n  n  Take selective risks: n  n  n  Warren Buffett: “We have usually made our best purchases when apprehensions about some macro event were at a peak.” Is fear warping your perception of risk? If you endured the last 15 years, hang in there. Exposure to factors like illiquidity, credit concerns, natural disasters and insurable events will be better rewarded than in the past century. Invest with a global perspective 22
  23. 23. History of U.S. Stock and Bond Returns Provides a Perspective for the Future Strictly Financials 23
  24. 24. Strictly Financials 24
  25. 25. Strictly Financials 25
  26. 26. Bonds as an Investment Strictly Financials 26
  27. 27. Strictly Financials 27
  28. 28. Long Term U.S. Treasury Rates and Inflation 16% 16% 14% 14% 12% 12% 10% 10% Bond Yield 8% 8% 6% 6% 4% 4% 2% 2% Inflation 0% 0% 54 57 60 63 66 69 72 75 78 81 84 87 90 93 96 99 '02 '05 '08 '11 '14 Bond Yield: Quarterly averages of long-term U.S. Treasury rates. Inflation: annual percent change in GDP deflator, annual percent change in Core PCE deflator from 1996 through 1999, market based Core PCE deflator from 2000. Through 2012. Strictly Financials Chart 1 28
  29. 29. “The Bond Buyer’s Dilemma” By Burton Malkiel in the WSJ, Dec 7, 2011 n  n  The yields on long term U.S. Treasuries will likely fall below inflation for the next several years - Long Term treasuries are likely to be sure losers Investors should consider as alternatives: n  n  Bonds with moderate credit risk where the spreads over treasuries are generous. n  Tax exempt municipal bonds are especially attractive n  Foreign bonds in fiscally secure countries, e.g. Australia High quality U.S. stocks with generous dividend yields n  Abbott Labs, ATT, Exxon, J&J, P&G. Strictly Financials 29
  30. 30. Strictly Financials 30
  31. 31. THE VIX – A MEASURE OF EXPECTED MARKET VOLATILITY (RISK). Strictly Financials 31
  32. 32. You Can Keep Track of Current Market Volatility with the VIX n  n  n  The “VIX” is a measure of the market’s perception about market uncertainty over the next 30 days. It’s derived from the Black-Scholes “option pricing model” of which one input value is expected volatility (ie. future standard deviation) of the S&P 500. You make the calculation by “solving the model backwards” – that is “given the observed price, what volatility is needed to produce that price by the model.” Strictly Financials 32
  33. 33. Historic Volatility Since 1898 30-Day Historic Volatility for U.S. Stock Indexes -(DJIA 1898 - 1956, and S&P 500 for 1957 and later years) 30-day volatility at the end of week 120 99.84 on Nov. 29, 1929 100 87.50 on Nov. 20, 1987 80.85 on Nov. 14, 2008 80 60 Maximum Minimum Mean Median 40 99.84 3.21 15.51 12.95 20 0 1/7/1898 4-Mar-1921 26-Nov-1943 8-Jul-1966 25-Aug-1989 6-Apr-2012 (Jan 7, 1898 - April 27, 2012) Source: Bloomberg “Historic Volatility” is a measure of actual price changes during a specific time period in the past. Mathematically, historic volatility is the annualized standard deviation of daily returns during a specific past period. Strictly Financials 6 33
  34. 34. Stock and Bond Returns If Markets are “Efficient” …. Market efficiency refers to how quickly security prices reflect new information. If markets are efficient it isn’t possible to “beat the market” 34
  35. 35. Implications of Market Efficiency for Investors n  n  n  n  Stock experts don’t have an advantage over amateurs because the competition is so severe Investment return will be a function of risk. The key factor in market efficiency is information. Most SEC regulation is designed to promote the flow of information to investors. Technical analysis is valueless because market participants already have incorporated any information contained in past price sequences into stock prices Strictly Financials 35
  36. 36. Implications (con’t) n  n  n  n  Fundamental analysis and brokerage firm recommendations will not enable you to identify firms which will outperform the market. Information contained in accounting statements and other public information already is reflected in security prices. It makes no sense to try and time the market. If markets can be “beaten” the way is not obvious. Strictly Financials 36
  37. 37. How Then Should We Invest as Retail Investors? 1.  Buy and hold a well-diversified portfolio through time – and make sure you have exposure to international stocks and bonds – in developed and emerging markets. 2.  Minimize fees, trading costs and expense ratios. 3.  Minimize tax impacts of buying and selling. 4.  Rebalance periodically to your risk/reward target Strictly Financials 37
  38. 38. So, What Does All Of This Data Tell Us? n  n  n  n  First, remember when people say “this time is different,” it is never different. Markets over and under correct, but they ultimately revert to the mean of their long term values. Periods of over performance will be followed by periods of underperformance, etc. Diversification is a key strategy for investing. Strictly Financials 38
  39. 39. Diversification in an Institutional Investor Portfolio 1)  2)  3)  4)  5)  6)  7)  8)  Stocks - Large cap, small cap, growth, value, international including emerging markets Fixed income – Treasuries, high yield, corporate, municipal Real Estate – REITs, direct investment funds MLPs – Transportation, E&P, Liquids, Storage Commodities – Ags, metals, oil and gas, Precious metals – Gold, silver Hedge Funds – Various types Risk management tools – Options, futures Strictly Financials 39
  40. 40. How Demographics Will Drive International Investing Activity Strictly Financials 40
  41. 41. The Changing Demographics of Major Countries 1.  2.  Countries with larger numbers of younger workers will enjoy higher growth rates than “older” countries. Demand for housing, autos, and consumer goods is driven by the 25 to 45 year old age cohort. 41
  42. 42. United States 42
  43. 43. Italy 43
  44. 44. Germany 44
  45. 45. China 45
  46. 46. Brazil 46
  47. 47. India 47

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