Financial statement analysis


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Financial statement analysis

  1. 1. Bus 315 – Week 12 Ch.15 Financial Statement Analysis
  2. 2. Financial Statements <ul><li>Balance Sheet </li></ul><ul><ul><li>Common Sized (all items expressed as a percentage of total sales); allows for viewing some valuable information instantly and comparing to other firms and/or periods </li></ul></ul><ul><ul><li>Trend or Indexed </li></ul></ul><ul><li>Income Statement </li></ul><ul><ul><li>Common Sized (all items expressed as a percentage of sales) </li></ul></ul><ul><li>Statement of Changes in Financial Position (statement of cash flows) </li></ul>
  3. 3. Return on Equity (ROE) and Return on Assets (ROA) <ul><li>ROE determines growth in earnings </li></ul><ul><li>ROE depends on ROA (EBIT/assets), debt-to-equity ratio, interest rate paid on debt, and tax rate </li></ul><ul><li>Leverage and ROE </li></ul><ul><ul><li>Leverage magnifies ROA to ROE </li></ul></ul><ul><ul><li>ROE responds to the debt-to-equity ratio </li></ul></ul><ul><li>Calculate ROE for a firm that has ROA of 10%, pays 8% interest on its debt, 40% income tax, and maintains debt-to-equity ratio of 2/3. </li></ul>
  4. 4. DuPont Decomposition of ROE <ul><li>ROE=Net profit/Equity </li></ul><ul><li>Original DuPont decomposition into profit margin, asset turnover and leverage multiplier </li></ul><ul><li>Extended DuPont analysis </li></ul><ul><li>ROE=(Profit margin*Asset Turnover-Interest expense ratio)* </li></ul><ul><li>Financial leverage*Tax retention rate </li></ul><ul><li>Note that, ROA=EBIT/Assets=Margin*Turnover </li></ul>
  5. 5. DuPont Decomposition: Example <ul><li>Use the data from table to decompose the ROE using original DuPont decomposition and comment on the trends in the performance of the company </li></ul>Year 20X5 20X6 20X7 Net income 21.5 22.3 21.9 Sales 305 350 410 Equity 119 124 126 Assets 230 290 350 ROE 18.1 18 17.4 DuPont 7%x1.32x1.93 6.4%x1.21x2.34 5.3%x1.17x2.78
  6. 6. Ratio Analysis <ul><li>Purpose of ratio analysis is to calculate compare the firm’s ratios to other firm’s ratios or ratios from the same firm in different period </li></ul><ul><ul><li>Comparative analysis: comparison to industry mean (median) is widely used; comparison to similar firms; comparison to aggregate economy </li></ul></ul><ul><ul><li>Trend analysis: compare to the ratios of the same firm in different period to see the changes </li></ul></ul><ul><ul><li>It is desirable if the values are close to industry averages </li></ul></ul><ul><li>Use by External Analysts </li></ul><ul><ul><li>Important information for investment community </li></ul></ul><ul><ul><li>Important for credit markets; used for determining credit rating of firms </li></ul></ul>
  7. 7. Limitations of Financial Ratios <ul><li>Not useful when viewed in isolation, only valid when comparing to other firms/periods </li></ul><ul><li>Comparison across companies may be difficult because of different accounting treatments </li></ul><ul><li>Difficult to find industry ratios for firms operating in several industries </li></ul><ul><li>Ratios have to be viewed relative to one another </li></ul><ul><li>Acceptable ranges of values have to be assumed for comparison </li></ul>
  8. 8. Types of Financial Ratios <ul><li>The main areas of firm that can be assessed by ratio analysis are liquidity, performance, risk, and growth potential </li></ul><ul><li>Liquidity Ratios are calculated to see the firm’s ability to pay its’ short-term obligations </li></ul><ul><li>Performance Ratios show how well the management operates business </li></ul><ul><li>Risk analysis evaluates uncertainty of firm’s cash flows (financial leverage) </li></ul><ul><li>Growth potential (DuPont analysis) </li></ul>
  9. 9. Translating financial statements language <ul><li>Gross profits=Net sales-COGS </li></ul><ul><li>Operating profits=EBIT </li></ul><ul><li>Net income=Earnings after taxes but before dividends </li></ul><ul><li>Total capital=Short-term Debt+Long-term Debt+Equity </li></ul><ul><li>Net sales-COGS=Gross profit -> </li></ul><ul><li>Gross profit –Operating expenses=EBIT -> </li></ul><ul><li>EBIT-Interest-Earnings before taxes (EBT) -> </li></ul><ul><li>EBT-Taxes-Earnings after taxes (EAT) </li></ul>
  10. 10. Liquidity ratios <ul><li>Current ratio: the higher the short ratio the more probable that firm will be able to pay its’ short-term expenses </li></ul><ul><li>Quick ratio similar to current ratio but does not include the less liquid inventories </li></ul><ul><li>When calculating the ratios involving balance sheet items we use the year’s averages (of beginning of the year and end of the year values) </li></ul>
  11. 11. Activity or Management Efficiency Ratios <ul><li>Inventory turnover shows how efficient is inventory management: higher values are better </li></ul><ul><li>Total asset turnover: higher numbers are better. However, the values depend a lot on industry (manufacturing vs retail). Can calculate the same for just fixed assets </li></ul>
  12. 12. Activity or Management Efficiency Ratios (2) <ul><li>Average Collection Period shows how good the credit policy is. Calculates the average number of days it takes for customers to pay the bills </li></ul><ul><li>Inventory Processing period calculates how many days it takes to sell the inventories </li></ul><ul><li>Payables turnover period shows the use of trade credit </li></ul>
  13. 13. Activity or Management Efficiency Ratios (3) <ul><li>Cash conversion cycle is the length of time it takes to turn cash investments in inventory back into cash by collecting sales of inventories (finished goods). Average receivables, average payables, and inventory processing period are used of calculating this ratio. Long cash conversion cycles are undesirable as it implies that high amount of capital is tied in the sales process </li></ul>
  14. 14. Leverage Ratios <ul><li>Times interest earned ratio shows how big are interest payments relative to EBIT. Similar measure can be used with fixed payments (lease payments, preferred dividend, principal repayments). High values show ability to repay payments without problem </li></ul><ul><li>Long term debt to assets ratio shows the percentage of firm assets financed by issuing debt. High debt ratio makes firm more risky as higher fixed payments have to be made every period leaving shareholders the residual. [This ratio can also be expressed as debt-to-equity] </li></ul><ul><li>Note: assets=liabilities=short term debt+long-term debt+preferred and common equity </li></ul>
  15. 15. Profitability Ratios <ul><li>Net profit margin is the ratio of income to sales. Low values mean low profitability of business. Number should be based on the income from continuing operations as this would tell us about the long-run future prospects </li></ul><ul><li>Return on assets (on total capital) </li></ul><ul><li>Return on equity is the ratio of income to total equity (including preferred equity). Ratio can also be computed for just common equity. Low value is bad. </li></ul>
  16. 16. Economic Value Added <ul><li>Difference between return on assets (ROA) and the opportunity cost of capital (k) </li></ul><ul><li>EVA = (ROA-k)*invested capital </li></ul><ul><li>EVA can be positive or negative for firms that have positive earnings </li></ul>
  17. 17. Comparability Problems <ul><li>Accounting Differences </li></ul><ul><ul><li>Inventory Valuation </li></ul></ul><ul><ul><li>Depreciation </li></ul></ul><ul><li>Inflation </li></ul><ul><li>International Accounting Conventions </li></ul><ul><li>Quality of Earnings </li></ul><ul><ul><li>Concept refers to the extent to which one may expect reported level of earnings to be sustained </li></ul></ul><ul><ul><li>Factors influencing quality of earnings: </li></ul></ul><ul><ul><ul><li>Allowance for bad debt </li></ul></ul></ul><ul><ul><ul><li>Nonrecurring items </li></ul></ul></ul><ul><ul><ul><li>Stock options </li></ul></ul></ul>