Financial Analysis

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Financial Analysis

  1. 1. The Analysis of Financial Statements Ratios are tools and their value is limited when used alone. The more tools used, the better the analysis. For example, you can’t use the same golf club for every shot and expect to be a good golfer. The more you practice with each club, however, the better able you will be to gauge which club to use on one shot. So to, we need to be skilled with the financial tools we use. - Diane Morrison - CEO, R.E.C. Inc.
  2. 2. Objectives of Analysis <ul><li>Remember--the identity of the user helps define what information is needed </li></ul><ul><li>Objectives will vary depending on the </li></ul><ul><li>perspective of the financial statement user </li></ul><ul><li>specific questions that are addressed </li></ul><ul><li>by the analysis </li></ul>
  3. 3. Creditors <ul><li>A creditor is ultimately concerned with the ability of an existing or prospective borrower to make interest and principal payments on borrowed funds </li></ul>
  4. 4. Investors <ul><li>An investor attempts to arrive at an estimation of a company’s future earnings stream in order to attach a value to the securities being considered for purchase or liquidation </li></ul>
  5. 5. Tools and Techniques <ul><li>Common-size financial statements </li></ul><ul><li>Financial ratios </li></ul><ul><li>Trend analysis </li></ul><ul><li>Industry comparisons </li></ul>These include: Most important: Common sense and judgment
  6. 6. Common-Size Financial Statements <ul><li>Express each account on the </li></ul><ul><li>balance sheet as a percentage of total assets </li></ul><ul><li>income statement as a percentage of net sales </li></ul>
  7. 7. Key Financial Ratios <ul><li>Standardize financial data in terms of mathematical relationships expressed in the form of </li></ul>Percentages Times Days
  8. 8. Key Financial Ratios (cont.) <ul><li>Liquidity (Short-term liquidity) </li></ul><ul><li>Activity </li></ul><ul><li>Leverage (Long-term solvency) </li></ul><ul><li>Profitability </li></ul><ul><li>Market </li></ul>
  9. 9. Liquidity Ratios: Short-Term Solvency <ul><li>Measures ability to meet short-term cash needs </li></ul>Current Ratio Current assets Current liabilities
  10. 10. Liquidity Ratios: Short-Term Solvency (cont.) <ul><li>Measures ability to meet short-term cash needs more rigorously by eliminating inventory </li></ul>Quick or Acid-Test Ratio Current assets - Inventory Current liabilities <ul><ul><li>(Cash+short-term investments + A/R) </li></ul></ul><ul><ul><li>current liabilities </li></ul></ul>
  11. 11. Liquidity Ratios: Short-Term Solvency (cont.) <ul><li>Focuses on ability of the firm to generate operating cash flows as a source of liquidity </li></ul>Cash Flow Liquidity Ratio *Cash flow from operating activities Cash + Marketable securities + CFO * Current liabilities
  12. 12. Liquidity Ratios
  13. 13. Activity Ratios: Asset Liquidity, Asset Management Efficiency <ul><li>Another measure of efficiency of firm’s collection and credit policies </li></ul>Accounts Receivable Turnover
  14. 14. Activity Ratios: Asset Liquidity, Asset Management Efficiency (cont.) <ul><li>Another measure of firm’s efficiency in managing its inventory </li></ul>Inventory Turnover
  15. 15. Activity Ratios: Asset Liquidity, Asset Management Efficiency (cont.) <ul><li>Another way to gain insight into a firm’s pattern of payment to suppliers </li></ul>Payables Turnover
  16. 16. Cash Conversion Cycle or Net Trade Cycle <ul><li>Buying or manufacturing inventory, with some purchases on credit </li></ul><ul><li>Selling inventory, with some sales on credit </li></ul><ul><li>Collecting the cash </li></ul>The normal cycle of a firm that consists of:
  17. 17. Cash Conversion Cycle or Net Trade Cycle (cont.) <ul><li>Key balance sheet accounts that affect cash flow from operating activities </li></ul><ul><li>Accounts Receivable </li></ul><ul><li>Inventory </li></ul><ul><li>Accounts Payable </li></ul>Helps the analyst understand why cash flow generation has improved or deteriorated by analyzing:
  18. 18. Cash Conversion Cycle or Net Trade Cycle (cont.) <ul><li>Average collection period </li></ul><ul><li>Plus </li></ul><ul><li>Days inventory held </li></ul><ul><li>Minus </li></ul><ul><li>Days payable outstanding </li></ul><ul><li>Equals </li></ul><ul><li>Cash conversion or net trade cycle </li></ul>Calculated as follows:
  19. 19. Activity Ratios: Asset Liquidity, Asset Management Efficiency (cont.) <ul><li>Assesses effectiveness in generating sales from investments in fixed assets </li></ul>Fixed Asset Turnover Net sales Net property, plant, equipment (Average)
  20. 20. Activity Ratios: Asset Liquidity, Asset Management Efficiency (cont.) <ul><li>Assesses effectiveness in generating sales from investments in all assets </li></ul>Total Asset Turnover Net sales Total assets (Average)
  21. 21. Activity Ratios - Summary
  22. 22. Activity Ratios - Summary
  23. 23. Leverage Ratios: Debt Financing and Coverage <ul><li>Considers the proportion of all assets that are financed with debt </li></ul>Debt Ratio Total liabilities Total assets
  24. 24. Leverage Ratios: Debt Financing and Coverage (cont.) <ul><li>Reveals the extent to which long-term debt is used for the firm’s permanent financing (both long-term debt and equity) </li></ul>Long-term Debt to Total Capitalization Long–term debt Long-term debt + Stockholders’ equity
  25. 25. Leverage Ratios: Debt Financing and Coverage (cont.) <ul><li>Measures the riskiness of the firm’s capital structure in terms of the relationship between the funds supplied by creditors (debt) and investors (equity) </li></ul>Debt to Equity Total liabilities Stockholders’ equity
  26. 26. Leverage Ratios: Debt Financing and Coverage (cont.) <ul><li>Indicates how well operating earnings cover fixed interest expenses </li></ul>Times Interest Earned Operating profit Interest expense
  27. 27. Leverage Ratios: Debt Financing and Coverage (cont.) <ul><li>Measures how many times interest payments can be covered by cash flow from operations before interest and taxes </li></ul>Cash Interest Coverage CFO + interest paid + taxes paid Interest paid
  28. 28. Leverage Ratios: Debt Financing and Coverage (cont.) <ul><li>Broader measure of how well operating earnings cover fixed charges </li></ul>Fixed Charge Coverage *Rent expense = operating lease payments Operating profit + Rent expense Interest expense + Rent expense
  29. 29. Leverage Ratios: Debt Financing and Coverage (cont.) <ul><li>Measures firm’s ability to cover capital expenditures, long-term debt payments and dividends each year </li></ul>Cash Flow Adequacy Cash flow from operating activities Capital expenditures + debt repayments + dividends paid
  30. 30. Leverage Ratios: Debt Financing and Coverage Summary
  31. 31. Profitability Ratios: Overall Efficiency and Performance <ul><li>Measures ability to translate sales into profit after consideration of cost of products sold </li></ul>Gross Profit Margin Gross profit Net sales
  32. 32. Profitability Ratios: Overall Efficiency and Performance (cont.) <ul><li>Measures ability to translate sales into profit after consideration of operating expenses </li></ul>Operating Profit Margin Operating profit Net sales
  33. 33. Profitability Ratios: Overall Efficiency and Performance (cont.) <ul><li>Measures ability to translate sales into profit after consideration of all expenses and revenues, including interest, taxes and nonoperating items </li></ul>Net Profit Margin Net earnings Net sales
  34. 34. Profitability Ratios: Overall Efficiency and Performance (cont.) <ul><li>Measures ability to translate sales into cash (with which to pay bills!) </li></ul>Cash Flow Margin Cash flow from operating activities Net sales
  35. 35. Profitability Ratios: Overall Efficiency and Performance (cont.) <ul><li>Measures rate of return on stockholders’ investment </li></ul>Return on Equity (ROE) Net earnings Stockholders’ equity (Average)
  36. 36. Profitability Ratios: Overall Efficiency and Performance (cont.) <ul><li>Measures overall efficiency of firm in managing investment in assets and generating profits </li></ul>Return on Total Assets (ROA) or Return on Investment (ROI) Net earnings Total assets (Average)
  37. 37. Relating the Ratios —The Du Pont System <ul><li>Is helpful to complete the evaluation of a firm by considering the interrelationship among the individual ratios </li></ul>The Du Pont System helps the analyst see how the firm’s decisions and activities over the course of an accounting period interact to produce an overall return to the firm’s shareholders, the return on equity
  38. 38. Relating the Ratios —The Du Pont System (cont.) The summary ratios used are the following: (1) Net profit margin (2) Total asset turnover (3) Return on investment (3) Return on investment (4) Financial leverage (5) Return on equity Net income Net sales Net income Net sales X Total assets = Total assets Net income Total assets Net income Total assets X Stockholder equity = Stockholder equity
  39. 39. Profitability Ratios: Overall Efficiency and Performance (cont.) <ul><li>Measures firm’s ability to generate cash from the utilization of its assets </li></ul><ul><li>Useful comparison to ROA </li></ul>Cash Return on Assets Cash flow from operating activities Total assets (Average)
  40. 40. Profitability Ratios-Summary
  41. 41. Profitability Ratios-Summary
  42. 42. Market Ratios <ul><li>Earnings per common share </li></ul><ul><li>Price-to-earnings </li></ul><ul><li>Dividend payout </li></ul><ul><li>Dividend yield </li></ul>Four market ratios of particular interest to the investor are
  43. 43. Market Ratios (cont.) <ul><li>Provides the investor with a common denominator to gauge investment returns </li></ul>Earnings per Common Share Net earnings Average shares outstanding
  44. 44. Market Ratios (cont.) <ul><li>Relates earnings per common share to the market price at which the stock trades, expressing the “multiple” that the stock market places on a firm’s earnings </li></ul>Price-to-Earnings Market price of common stock Earnings per share
  45. 45. Market Ratios (cont.) <ul><li>Determined by the formula cash dividends per share divided by earnings per share </li></ul>Dividend Payout Dividends per share Earnings per share
  46. 46. Market Ratios (cont.) <ul><li>Shows the relationship between cash dividends and market price </li></ul>Dividend Yield Dividends per share Market price of common stock
  47. 47. Market Ratios
  48. 48. Financial Analysis <ul><li>Credit Analysis </li></ul><ul><li>Equity Analysis </li></ul>
  49. 49. Creditors <ul><li>What is the borrowing cause? </li></ul><ul><li>What is the firm’s capital structure? </li></ul><ul><li>What will be the source of debt repayment? </li></ul>
  50. 50. Credit Rating <ul><li>Business Risk </li></ul><ul><ul><li>Industry characteristics </li></ul></ul><ul><ul><li>Company position </li></ul></ul><ul><ul><li>Management </li></ul></ul><ul><li>Financial Risk </li></ul><ul><ul><li>Financial characteristics </li></ul></ul><ul><ul><li>Financial Policy </li></ul></ul><ul><ul><li>Profitability </li></ul></ul><ul><ul><li>Capital Structure </li></ul></ul><ul><ul><li>Cash Flow Protection </li></ul></ul><ul><ul><li>Financial flexibility </li></ul></ul>
  51. 51. Standard & Poor’s rating method <ul><li>EBIT interest coverage </li></ul><ul><li>EBITDA interest coverage </li></ul><ul><li>Funds from operations/Total debt % </li></ul><ul><li>Free operating cash flow/Total debt % </li></ul><ul><li>Return on capital % </li></ul><ul><li>Operating income/Sales </li></ul><ul><li>Long-term debt/Capital </li></ul><ul><li>Total debt/Capital </li></ul>
  52. 52. Standard and Poors Corporate Ratings
  53. 53. Financial distress <ul><li>The deterioration in a company’s financial condition such that its ability to repay debt is impaired </li></ul>
  54. 54. Prediction of financial distress Univariate models <ul><li>Beaver (1966) relied on </li></ul><ul><ul><ul><li>Cash flow to total debt </li></ul></ul></ul><ul><ul><ul><li>Net income to total assets </li></ul></ul></ul><ul><ul><ul><li>Total debt to total assets </li></ul></ul></ul><ul><ul><ul><li>Working capital to total assets </li></ul></ul></ul><ul><ul><ul><li>Current ratio </li></ul></ul></ul><ul><ul><ul><li>No-credit (defensive) interval </li></ul></ul></ul>
  55. 55. Prediction of financial distress Multivariate models <ul><li>Altman Z-score </li></ul><ul><ul><li>(Current assets – current liabilities)/total assets (weight -1,2 ) </li></ul></ul><ul><ul><li>Retained earnings/Total assets (weight -1, 4) </li></ul></ul><ul><ul><li>EBIT/Total assets (weight - 3 , 3) </li></ul></ul><ul><ul><li>Preferred and common stock market value/Book value of liabilities (weight - 0 , 6) </li></ul></ul><ul><ul><li>Sales/Total assets (weight -1, 0) </li></ul></ul>
  56. 56. Altman Z-score <ul><li>Z> 2,99  Not in financial distress </li></ul><ul><li>Z< 1,81  In financial stress </li></ul><ul><li>2,99>Z>1,81  Uncertain </li></ul>
  57. 57. Altman Z score Anadolu Cam
  58. 58. Additional considerations <ul><li>Mezzanine items </li></ul><ul><ul><li>Could be debt or equity </li></ul></ul><ul><li>Off-balance-sheet liabilities </li></ul><ul><ul><li>Operating leases </li></ul></ul><ul><ul><li>Contingent liabilities </li></ul></ul><ul><ul><li>Environmental liabilities </li></ul></ul>
  59. 59. Equity Analysis <ul><li>Buy-side </li></ul><ul><ul><li>Work for an institutional investors (mutual fund) </li></ul></ul><ul><ul><li>Make internal recommendations regarding the purchase of equity securities </li></ul></ul><ul><ul><li>Might review reports of sell-side analysts </li></ul></ul><ul><li>Sell-side </li></ul><ul><ul><li>Work for brokerage firms </li></ul></ul><ul><ul><li>Issue reports for retail and institutional customers </li></ul></ul>
  60. 60. Valuation <ul><li>Current value V 0 is a function of </li></ul><ul><ul><li>Present value of next year’s cash flow, CF 1 </li></ul></ul><ul><ul><li>Required rate of return, r </li></ul></ul><ul><ul><li>Expected constant growth rate, g </li></ul></ul>
  61. 61. Equity Analysis <ul><li>Provides information regarding </li></ul><ul><li>The future cash flow generating ability of the firm </li></ul><ul><li>The growth (or lack thereof) of those cash flows </li></ul><ul><li>The risk of those cash flows, and </li></ul><ul><li>The risk-free rate commanded by the market </li></ul>
  62. 62. Top-Down Analysis <ul><li>Begin at highest (economy) level </li></ul><ul><ul><li>Allocation between domestic and international equities </li></ul></ul><ul><li>Market sectors </li></ul><ul><li>Industries (within a sector) </li></ul><ul><li>End with evaluation of specific companies </li></ul>
  63. 63. Bottom-Up Analysis <ul><li>Begin with individual companies </li></ul><ul><ul><li>Look for key strengths </li></ul></ul><ul><li>Screen large data bases for attractive characteristics </li></ul><ul><ul><li>Compustat, Bloomberg, Baseline </li></ul></ul><ul><li>Search for a combination of characteristics </li></ul>
  64. 64. Five Steps of a Financial Statement Analysis <ul><li>Who are you and why are you interested in this company? </li></ul><ul><li>What questions would you like to have answered? </li></ul><ul><li>What info is vital to the decision at hand? </li></ul>Establish objectives of the analysis Step 1
  65. 65. Five Steps of a Financial Statement Analysis (cont.) <ul><li>Study the industry in which the firm operates and relate industry climate to current and projected economic developments </li></ul>Step 2
  66. 66. Five Steps of a Financial Statement Analysis (cont.) <ul><li>How well does this firm appear to be run? </li></ul><ul><li>Are they taking advantage of opportunities? </li></ul><ul><li>Are they innovative, forward-looking, etc? </li></ul>Step 3 Develop knowledge of the firm and the quality of management
  67. 67. Five Steps of a Financial Statement Analysis (cont.) <ul><li>Common-size financial statements </li></ul><ul><li>Key financial ratios </li></ul><ul><li>Trend analysis </li></ul><ul><li>Comparison with industry competitors </li></ul>Step 4 Evaluate financial statements– tools include:
  68. 68. Five Steps of a Financial Statement Analysis (cont.) <ul><li>Short-term liquidity </li></ul><ul><li>Operating efficiency </li></ul><ul><li>Capital structure and long-term solvency </li></ul><ul><li>Profitability </li></ul><ul><li>Market ratios </li></ul><ul><li>Segmental analysis (when relevant) </li></ul>Step 4 Evaluate financial statements– areas include:
  69. 69. Five Steps of a Financial Statement Analysis (cont.) <ul><li>Reach conclusions about the firm relevant to your established objectives </li></ul>Step 5 Summarize findings based on analysis
  70. 70. Financial Statements An Overview Map

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